I know you want to generate capital gains in the stock market. You need to use a strategy that fits the current market environment and your own personality to do that.
There are two basic investing methods that successful investors use to make money. They either use a growth or value oriented approach to investing, which looks for companies whose earnings are rapidly growing or whose stock is undervalued, or they employ technical analysis, which examines prior price and volume movements in order to forecast the future price movements of financial assets.
Some investors use a combination of strategies, such as William O'Neill who combines a growth and technical approach to investing in his book How to Make Money in Stocks and in his newspaper, Investor's Business Daily.
Growth investors base their investment decisions on a study of the earnings of a company, but completely disregard valuations. They don't care if a stock is highly valued, only that earnings are growing quickly. William O'Neill is the most popular proponent of growth investing. He looks for companies whose quarterly earnings are up at least 20% from a year ago, whose annual compounded earnings per share should be between at least 15% for the past five years, and who have a new product or service that will help it capture market share. Although O'Neill then takes into consideration how strong the stock is when compared to the rest of the market and the general phase of the market, most pure growth stock investors do not worry about the position of the market or the stock itself.
Even though growth stocks tend to outperform the rest of the stock market during bull markets, growth stock investing holds special risks. Part of the reason why growth stocks do so well is that their earnings tend to surprise analysts to the upside. That catches the attention of investors and causes traders to buy the stock in hopes that the company will surprise again, causing the stock to become highly valued.
The problem with growth companies is that at some point the growth slows down. Usually this happens right as the excitement surrounding the company is at a crescendo. The stock then usually falters and goes nowhere despite the continued good news. What is happening is that company insiders know that the future is not going to be as easy as the climb up to ascendancy and start to sell out ahead of the crowd, thereby putting a lid on any future price advances.
Because growth stocks tend to be highly valued they are susceptible to large and sudden drops on any negative news. An earnings warning or statements from a CEO that earnings are going to grow at a slower pace are enough to crush investors. Strategies based on growth stock investing in the 50 hottest stocks do not tell investors to sell until it is too late.
Value investing is the other way investors make money in the stock market. Warren Buffet is the most well known value investor. Value investors like buying stocks in companies that have big book value, pay out dividends, and do not have much debt on their balance sheet. In the best cases they can find a stock that is actually priced lower than the company itself, meaning the company could be sold for more than it stock price say it is worth. It is a bargain.
Most value investors look for companies whose stock is trading at a very low valuation due to a temporary market condition, such as low sales, a slow economy, or an extreme bearish sentiment in regards to the company that is unwarranted.
Sometimes a value investor has to wait a long time after buying a stock to see it go up, because the public stays scared and doesn't see the value in the stock. This can even happen in whole markets. Gold and commodities stayed at low prices until only a few years ago for example.
You need to know that it is the growth stocks that go up the most in bull markets, but they fall the most in bear markets too. It is the value investor who knows when to get in cheap and sell high. You have to figure out which strategy you like the most. I combine them both and talk about both.
