Finding the Turtles

After Dennis returned from a trip to Asia, he was quoted in the Wall Street Journal as saying: “We are going to grow traders just like they grow turtles in Singapore.” One of Dennis’s contemporaries, William Eckhardt disputed the claim that you could teach traders, maintaining that those best at trading had an instinct for it which could not be taught.

In order to settle the dispute, Dennis decided to set up an experiment whereby he would take on a group of students with no experience in trading, teach them his rules of trading and let them trade with real money. He believed in his theory so strongly that he put up his own money for the students to use. He then set up a two-week training course which could be repeated again and again.

An advertisement was placed in The Wall Street Journal which attracted thousands of applicants. Only 14 would make it through to become the turtle traders. Dennis admitted that he put a thorough screening process in place to decide on his final candidates and it could be argued that this process alone ensured that the experiment would result in a team of students with the inherent ability to succeed. The people chosen were carefully selected because they were able to display an aptitude for the type of trading they were to undertake.

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How the Turtle Trading System Worked

The training given to the students was weighted towards scientific method, meaning there was a set of rules which had to be strictly followed, based on observable, measurable evidence and reasoning. The method allowed for integrating newly acquired knowledge, so it could evolve with time as each trader gained experience. There were seven steps which mirrored the kind of procedure you might find in a laboratory experiment:

  1. Define the question
  2. Gather information and resources
  3. Form a hypothesis
  4. Perform an experiment and collect data
  5. Analyse the resulting data
  6. Interpret the data and draw conclusions that serve as a starting point for a new hypothesis
  7. Publish results

Clearly this is not how trading floors traditionally operate, but Dennis and Eckhardt were insistent that the students would approach trading using established scientific methods so that results could be replicated. The approach Dennis was taking relied on proving a theory using the trading numbers. He said of the experiment: “You need the conceptual apparatus to be the first thing you start with and the last thing you look at.”

Avoiding the hyped-up behaviour and emotive way of thinking that has always been synonymous with traders, and indeed any kind of gambling, was crucial to the turtle trading methodology.

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Trading on Trends

The system was based on following trends and riding on the momentum of an asset as it rises or falls, taking long or short positions accordingly. The mantra among the turtle strategy students was “trend is your friend”. They were taught to take positions on instruments that were breaking out to the upside and sell shortly after the downturn, or the other way around in the case of short positions. The result would be profiting from the majority of an uptick without trying to pick the top of the market.

This strategy minimised the need for a judgement call. It was based on the numbers. When the numbers indicated to buy or sell, that’s what the traders did, there was little discretion involved.

The algorithm the turtles used was based on position sizing, whereby the amount invested was adjusted according to the volatility of the instrument. This meant that smaller positions taken in high volatility instruments would be offset by larger positions in lower volatility instruments. The turtles would use a technique called pyramiding, which means increasing the size of positions as the asset price moves in the desired direction. They would also put a stop-loss order in place when taking a position, the amount of which was a fixed proportion, the same for every trade.

Results in the Early Years

The students of the turtle strategy were never expecting 100% results or to come out ahead on every trade they made. It was expected that bad trades were inevitable and when they happened, the turtles were to admit they were wrong, take note of the situation, accept their losses and move on. There was also, however, an expectation that over the long term, the turtles would make money and reports indicate that many of them were able to amass considerable sums over the four or so years the experiment ran.

In terms of actual results, a former turtle named Russell Sands said that out of two classes, each having between 10 and 14 individuals taught personally by Richard Dennis, earnings between them reached over $175m within five years. Starting stakes for individual traders were between $500,000 and $2m. Sands claims that the system still works today and someone who had started trading with $10,000 at the start of 2007 would have been able to finish the year with $25,000 despite the financial crisis, provided the original trading rules were followed. Despite the reported success of students taught by Dennis, this system is vulnerable to the downside as well, due to the fact that market moves which appear at first to be breakouts and cross the qualifying threshold frequently end up being false moves, which can result in cases of buying at the top of the market, in turn causing losses.

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Originating in Japan back in the sixties, the Ichimoku indicator or trading system is a potent trading tool used to recognise buy and sell signals during the process of trading on charts. It plays [...]

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Failing the Test of Time

The turtle strategy worked well for traders in the early 80s who were under the direct guidance of Richard Dennis, who was already well established as a talented trader before the turtle experiment was run. It is difficult to say whether this is because of the strategy itself or the skill of Dennis as a trader rubbing off on his students. There are conflicting opinions as to whether this kind of trend-based strategy would work today in a modern trading environment. There are those who say it does not.

A company called Trading Blox ran retrospective tests of the system based on markets from 1996 to 2009 and found returns to be flat. The unusual element of these tests was that when the same retrospective model was applied to the markets between 1970 and 1986 it returned 216% and when the test was applied to markets between 1986 and 2009, the results came back at a 10.5% gain. These results suggest several possibilities: that the system was suited for the era when the turtle experiment was carried out; that Dennis’ influence and his choice of turtles were driving factors in the traders’ success, or that it was a random outcome to the upside due mostly to luck. One could conclude that the system in its original guise doesn’t work in the modern trading environment, suggesting that the markets have changed in nature and the system needs to change accordingly.

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Following Trends Can Still Work

Other backtesting has shown that it is possible for trend-following trading strategies to be successful in more modern markets. A company called Trading Tuitions tested a trend-based system over a 12-year timeframe from 2004 to 2016 which returned between 20% and 30% with peak drawdowns of 17% to 40% depending on which index was traded. This strategy was based on a system developed by a trend-trading guru called Richard Donchian, who was one of the inspirations for Richard Dennis’ turtle trading model. The fact that trend trading can still make returns does show that while turtle trading may not be in fashion, there may still be room for this type of strategy within a trading system.

  • Tests show trend-trading can bring positive returns
  • Turtle trading may still be relevant despite being out of style
  • Modifications to the original system allow it to be modernised

In addition, this test indicates that tweaking the system can cause drastic changes to the outcome. It suggests that it is highly likely that the fundamentals of a system such as the turtle trading are solid and there are ways today’s traders may use them to their advantage. It is the choppiness of today’s market conditions and the comparative rarity of longer-term trends that make trend trading less popular in the current climate.

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Market Indicators Based on the Method

Analyst organisations have developed numerous market indicators based on the turtle trading method. A market indicator is a type of technical indicator which takes a statistical formula and draws a conclusion by applying the formula to a set of data points drawn from multiple securities. It is a type of statistical analysis.

These market indicators have been shown to produce useful trading opportunities, particularly when the markets are showing trend patterns. This does not happen as often as it has in the past as markets tend to be choppier and using trending methods in choppy markets will result in more losing trades. When using this kind of market indicator, traders have to be watchful and steer clear of choppy conditions, the best tactic is to stay out of trades until a trending pattern starts to appear, a principle which has been the case since the original turtle trading experiment was run. If there are no trends happening, the system can’t be followed.

Modern traders who are using this kind of trading system will need to make use of some sort of filter to make sure risky trades are not made. The indicators and appropriate filters are available today in software form.

Conclusion:

Turtle Strategy – In Conclusion

The turtle trading experiment was a great success and most of the turtles went on to become successful traders. While they were turtles, as a group they managed to make large profits, bearing in mind they were also given very large sums of stake money. Some of the traders went on to become big names in the securities industry, for example, original turtle Jerry Parker eventually founded major fund management house Chesapeake Capital Management.

When making a broker comparison, any ability to identify and trade with trends is something to look for. Despite the specific turtle trading method having fallen out of favour, the techniques pioneered back in the early 80s still have relevance today and can form the basis of a successful trading strategy. Indeed, slightly under half of the original two groups of turtles are still trading today, which is around 10 individuals, many of whom have published books on the subject and still give lectures on the strategy.

The turtle trading strategy and trend trading in general still have a place in today’s trading world. The underlying principles remain unchanged and by all accounts are built around solid scientific principles. Some changes are needed to make them useable again, but provided the system is properly implemented and monitored, there is no reason why this kind of strategy cannot still make money.

Stocks Highlights

How Investors Look for Value Stocks

Stocks become undervalued because of the irrational behaviour of investors. Value investing schemes seek to take advantage of this irrational behaviour by buying stocks that display below average price-to-book ratios or price-to-earnings ratios, particularly if they show strong dividend yields at the same time. Provided these figures fall below a company’s intrinsic value, the stocks are a good buy for value investors. This raises the need for an accurate estimation of the company’s intrinsic value. This is a subjective value, and two different analysts will most likely come up with different values despite being given the same information. A “margin of safety” also needs to be incorporated when estimating intrinsic value. Both these factors will be examined in more detail later on.

Regardless of the approach taken by the investor when looking for value stocks, the business of value estimation is subjective. Some investors look at current earnings and asset value without attempting to project future growth. Others take future growth and earnings estimates into account, along with other factors such as past performance and the perceived market demand for the type of product or service. One way or another, the goal is to determine which stocks are undervalued and likely to experience growth in the near to mid-term. Much of the time, value investors will be of the opinion that the market has overreacted to public information, causing price movements that do not match the future performance potential of the underlying company.

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Contradicting Other Strategies

The theory that underpins value investing is at odds with another well-known theory on financial markets, known at the efficient market hypothesis. The EMH theorises that it is not possible to beat the market because share prices account for all relevant information, which is immediately reflected in price movements. The EMH assumes that stocks always trade at their correct and fair value, making under or overvaluation impossible. The EMH also says that it is not possible for an investor to outperform the market by making shrewd stock picks or having expert timing skills. Instead, under the EMH, it is only possible to create returns by taking on higher levels of risk. Despite this contradiction with the EMH, proponents of value investing have shown that it is indeed possible for stocks to be undervalued.

The markets have demonstrated time and time again that stock prices do not necessarily reflect the true value of the underlying assets, meaning that it is indeed possible for stocks to be undervalued. Famous investor Warren Buffett has on many occasions demonstrated that value investing is not only possible, but if it is done correctly, it can also be highly profitable. This does not mean that profits from value investing are easy to come by – it takes a high level of skill to identify which stocks are undervalued and which are just cheap.

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Strong Fundamentals Are Essential

One of the main traits those following a value investing model seek is strong fundamentals – such quantifiable elements as strong earnings, regular and consistent dividends, solid cash flow and healthy book value. Value investors don’t just look for the cheapest stocks, as that’s not how to identify value stocks. What constitutes value is low price relative to the health of the company’s fundamentals.

  • Fundamentals are key to success
  • Cheapest is not always best
  • A low-priced, well-run company is the ideal stock target

The way value investors view their role is different to other kinds of traders. When value investors buy into a company, they will see themselves as shareholder owners, as opposed to those using trading strategies of just flipping stock for a profit. They are looking to take part ownership of high-quality companies through their stock investment and will view the companies as assets, rather than a means to an asset. Their method is based around being aware of a company’s worth, so they largely ignore outside influencing factors, such as the state of the overall market and price fluctuations, and concentrate on the appropriate and responsible operation of the business. Fundamentals rule over market forces for value investors.

Ways to Identify Potential Target Shares

The next step in becoming a value investor is to perform a broker comparison and establish which is the best source for stock purchases. Once you have decided on a place to purchase stocks, it’s time to narrow down which ones are the best for this kind of strategy. Value stocks trade on all the major worldwide stock exchanges, and these exchanges can be accessed through online brokerages. There is no specific sector where you are most likely to find value stocks, but there are some common traits to look for. The price-to-intrinsic value ratio is important. The share price should be no more than two-thirds the intrinsic value of the stock.

There are various advisory agencies and expert analysts that will give their opinion on stocks’ intrinsic value. Look for a low price-to-earnings ratio. This is a measure of the share price to the earnings per share. It can be calculated by dividing the share price by its most recent earnings-per-share figure. A value stock will be no more than 40% of its highest price-to-earnings ratio from the past five years. Shares with a low price-to-book ratio make good value shares. This figure is the current value divided by the book value from the latest earnings report. Once you have this value, compare it to averages from other companies in the sector.

Further Signs a Stock is Suitable

There are some other figures to examine when assessing a company’s suitability for value investing. It is important not to skip over any of these measures, as the key to success is only moving forward on stocks that tick the right boxes and not risking any investment on shares that are not quite fit for purpose just to save time or reduce the amount of work needed. Seek out shares with a low price/earnings to growth ratio, a measure of stock value derived from a company’s earnings growth. This figure is gained by dividing the price-earnings ratio figure by the amount the company’s earnings have grown over a specific time period. Investors looking for value stocks will aim for a price/earnings to growth ratio of below one. Be careful of companies that are too heavily leveraged. A low debt-to-equity ratio indicates the company does not owe too much debt. This figure can be realised by dividing total liabilities by the amount of stockholder equity. Once this figure is established, it should only be compared with companies in the same sector or industry to give a fair and accurate idea of whether the figure is low or not. Different sectors can be leveraged at greatly differing ratios, so it is important to be objective. Finally, the company dividend yield needs to be at least two-thirds of the current AAA-rated long-term bonds. This is an extra measure to be sure of having shares that will outperform.

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The Nuances That Go into Trading with Ichimoku: Things to Know in 2018

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Originating in Japan back in the sixties, the Ichimoku indicator or trading system is a potent trading tool used to recognise buy and sell signals during the process of trading on charts. It plays [...]

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Intrinsic Value and Margin of Safety

Intrinsic value is one of the primary figures that needs to be established for each stock being assessed for suitability as a value investment. In all the examples above, the intrinsic value is a benchmark against which the true value of the stock can be measured, and it is the key to knowing whether a stock is undervalued or not. Once the intrinsic value is established, traders also need to factor in a margin of safety, which acts as a buffer should the true intrinsic value be lower than estimates. This buffer limits the amount of unexpected downside exposure investors would otherwise have to deal with.

  • Make sure intrinsic value estimates are accurate
  • Always factor in a margin of safety
  • Don’t forget to examine fundamentals against intrinsic value

The importance of intrinsic value cannot be stressed enough, especially for beginners who are researching which stocks will add suitable value to a new portfolio. This, along with a thorough application of the analysis of fundamentals mentioned above, will go a long way to averting disasters further down the track. That said, estimating intrinsic value can be tricky. Analytics companies will put forward their own intrinsic value estimates, but it is not a good idea to rely on a single source. Instead, collect several values from multiple sources and look at the average to gain a better idea of the true intrinsic value. Then, on top of that, remember to factor in your margin of safety.

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Take Tips from a Pro

Value investing has some high-profile proponents. As mentioned earlier on, Warren Buffett is one of the most famous investors in the world, and this is one of his favoured strategies. He has some tips for success that are worth noting.

  • Diversification is not always best. When investing long-term, a few good picks are better and easier to track than many smaller ones.
  • Your best investment is in yourself. Make sure you are able to consistently make money regardless of how you do it. Don’t spend too much time investing if you are not making it your career.
  • Trust yourself. Once you have put in the work and come to a decision, stick by it and remember how you came to your decisions. Don’t second-guess your best judgement.
  • Don’t get out of your depth. It’s important to stay within your scope of understanding. If someone tries to talk you into investing in a business that you are not 100% clear about, walk away.
  • Pick your news sources carefully. This is particularly true today in the age of clickbait and fake news. Be sure sources upon which you base stock-picking decisions are reputable.
  • Learn from your mistakes. If you lose, take the lesson, be sure you understand what happened and why, then move on.
  • Avoid day trading. Long-term strategies create better profits, as they are more like real business and less like playing table games in a casino.

Keep these tips in mind before you begin trading.

Conclusion:

Our Verdict on Value Investing

No investment model is perfect, and there are no guarantees when it comes to the stock market. It is entirely possible to follow all the guidelines laid out above and still lose your investment. However, these methods have been tried and tested over time by professionals, and it makes logical sense that if you work hard at getting your strategy right, there will be a payoff at the end.

Making sure your analysis of fundamentals is thorough, avoiding being rash or impatient when it comes to locating undervalued stocks in which to invest, ensuring your company picks are in good financial health and being accurate with intrinsic values and margins of safety will go a long way to mitigating risk. While some losses are unavoidable and usually come from unforeseen events, it is possible to create a portfolio that is not overexposed to risk, while still generating acceptable returns. It really depends how much work you are prepared to put into ensuring you hold the right stocks that suit this type of strategy.

Stocks Highlights

How the Dividends are Captured

In this capture strategy guide, we will look at companies which operate a dividend model, paying their dividends annually, quarterly or in monthly instalments. When traders are working with a dividend capture strategy, they prefer to target those shares that pay annually, as it is easier to make the strategy profitable with low-frequency dividends as the amounts will be higher. There are financial websites which have calendars showing when dividends on various stocks fall due.

This strategy is appealing because of its simplicity. There is no complex analytics to examine, no complicated charts to consult. To take advantage of the strategy, you purchase the shares before the ex-dividend date and sell after the ex-dividend date, or sometime after that. Should the share price fall after the dividend is announced, you might choose to wait for the stock to rebound. The risk from this system comes if the stock drops and stays low. You don’t need to hold on to the shares until the pay date to collect your dividend payment. In theory, this strategy should not work because, in a perfect world, the dividend amount would be added to the share price until the ex-dividend date at which point the share price should fall by precisely the dividend amount. This rarely happens, however, and more often than not, a trader can “capture” the dividend and then sell the shares at only a slight loss after the ex-dividend date.

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Important Dates

  • Declaration date
    This is the date upon which the company states its intention to pay a dividend. The company will indicate how much the planned dividend will be, the ex-dividend date, and the payment date. Sometimes called the announcement date, the most reliable companies use a declaration schedule, so you should have some idea of when the declaration date will be and how frequently dividends are paid. Dividends from larger companies will be announced along with earnings reports and in separate press releases.
  • Ex-dividend date
    Anyone who buys stock after the ex-dividend date will not be entitled to a dividend that time around and will have to wait for the next dividend period to be paid. When attempting to capture dividends, you must buy the stock before the ex-dividend date. On the open of trading on a company’s ex-dividend date, shares are marked down by the amount of the declared dividend. Traders may purchase before the ex-dividend date and sell on or after that date and still be eligible for a dividend payment. The stock does not need to be held until the record or payment dates.
  • Record date
    This is the date that the company determines who is eligible for a dividend and falls the business day following the ex-dividend date. It is not of consequence to capture investors.
  • Payment date
    This is the date that dividends are distributed to shareholders. It is usually two weeks to a month after the ex-dividend date.

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Turning the Principle into a Strategy

Once you understand the principle behind how to capture dividends, next comes the task of putting it to work as an overall portfolio management strategy. The secret is in the diversity of stocks that can be used in this way. There are a lot of dividend stocks out there, meaning that almost every day there will be at least one stock due to pay its dividend. An investor needs to be continually rolling a large holding over regularly from one stock to the next, capturing the dividends from each one along the way. Provided this is done with a significant outlay, an investor may take advantage of multiple yield sizes, both small and large, and those yields can be compounded as they are re-invested into the next stock purchase. The optimal suggested returns to chase are in large-cap companies with mid-level yields of about 3% to ensure the lowest risk while still maintaining a useful level of payout.

  • Diversify stocks
  • Keep rolling over so new dividends are regularly upcoming
  • Make sure investment is made on a useful scale
  • Look to large-cap companies with mid-level yields

In addition to seeking out the highest-paying standard stocks, investors also spread their reach out to include foreign stocks trading on the major US and European exchanges as well as looking into exchange-traded funds that are set up to pay dividends.

The Costs of This System

Taxation plays a significant role in lowering profits from a dividend capture strategy. Since this is a strategy which involves collecting funds throughout the year, dividends that are paid are subject to taxation, which is different from buy-and-hold growth strategies. This means that to realise the full potential of this trading system, large share amounts need to be purchased, which has the potential to price some smaller investors out of the market. The cost of transactions acts to decrease further the gross amount passing through the hands of a trader. There are instances where even though the dividend is more than the drop in share price after the ex-dividend date, adding transaction costs to that can reduce the capture amount, even more, resulting in significantly reduced profits or even losses in some cases. Because of this, it is essential to perform a broker comparison so that you are sure you are paying the lowest possible fees on share transactions.

All of this means that the potential gains are quite small, compared to the potential for losses due to the vast sums that need to be invested being hit by an unexpectedly large drop in share price during the holding period. Such a price drop can force the investor’s assets to remain tied up in the position for an extended time while the share price rebuilds. This introduces the element of company-specific and systemic risk into the system.

Other Ways to Approach the Dividend Cycle

The basic strategy outlined above is seen as a conservative form of equity investing, despite carrying a fair amount of risk and tax liability. There are, however, far more aggressive trading strategies with which to approach the dividend cycle. Basic dividend capture strategy relies on the markets not always being perfect or logical, for example it takes advantage of the fact that stock that is marked down on the ex-dividend date may not be marked down the full dividend amount, or it may not remain at the marked down price and experience an uptick in the following days or weeks.

Longer term forms of dividend capture strategy attempt to mitigate some of the risk involved. One way is to buy well ahead of the ex-dividend date as the days leading up to that date can see the stock outperform, buying in earlier in the cycle can secure the necessary shares at a lower price, paving the way for outsized returns when the stock is sold. Dividend capture strategy carries the risk of gains being wiped out by sudden, adverse market movements. To mitigate this kind of risk as much as possible, dividend capture traders often concentrate on sizeable blue-chip company stocks, held over the short term. Another variation of these strategies involves attempting to gain a higher percentage of the dividend through the purchase or sale of options which stand to profit when the stock price falls on the ex-dividend date.

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Drawbacks of Trying to Capture Dividends

While it seems like a relatively straightforward way of making a profit, there are several problems with this strategy which can make this strategy turn from a winner into a loser. Remember that the share price will be marked down on the ex-dividend date to reflect the dividend-price and deter investors from buying in, claiming the dividend that is intended for long-term investors, then selling immediately. This can mean that the markdown may be more than the dividend, may fall further with adverse market movement, and may take time to rebuild. Remember that there are other market factors at work such as supply and demand, any media attention the company may receive, and whether the company is posting a profit or loss. Market forces can work for and against a capture strategy, so the unwary investor can quickly post a loss if not paying close attention.

Depending on what tax jurisdiction you operate under, the short-term nature of the transaction will likely mean that taxes are due upon the sale of the stock. This can eat away at any potential profit. Another adverse effect on potential profit is brokerage fees which can build up if you don’t factor this cost into the strategy. To profit from this kind of approach, a significant capital outlay is required and trading large amounts of shares frequently can cause the commission fees from brokers to accumulate to a level that negates any profit gained.

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Special Dividends

Various research has shown that special dividend announcements can be more profitable than using dividend capture on regularly scheduled dividend payments. This is because special dividends are one-off announcements of dividend payments that are often much larger than, for example, regular quarterly dividends. Ordinary dividends are usually paid at about 1% to 2% of the stock’s trading value, while special dividends can be as high as 4% of the stock’s value or higher, depending on the nature of the event surrounding the special payout. The higher yield means captured profit is less likely to be negated by market fluctuations and broker fees. Some tips to follow are:

  • Buy on or shortly after the dividend announcement date
  • Do not buy close to the ex-dividend date
  • Be prepared to sell before the ex-dividend date

Remember there are two ways to take advantage of dividend payouts. Either buy low on or shortly after the announcement and sell on the day before the ex-dividend date, taking advantage of a price rise or, if the price rise is not significant, sell after you are included on the dividend list once the dropped price rises higher than the difference between the price prior to the ex-dividend date and the dividend itself.

Conclusion:

Capture Strategies

Dividend capture strategies are hard work. They require a lot of market research to find suitable stocks with a good history of paying substantial dividends. It is a relatively risk-intense form of trading requesting devotion to the cause to succeed in taking all the variable factors into account. If you are considering this type of strategy, you need to be prepared to put the time and effort in when it counts, which can be at short notice, particularly in the case of special dividends. Even if you put in the hard work, success is by no means guaranteed, and a passion for examining company performance is more of a necessity than a bonus.

That said, this strategy can and does have its rewards for those who are prepared to go to the trouble of implementing it in a disciplined fashion, have the considerable capital to invest, and are aware and able to offset the associated costs such as broker fees.

Stocks Highlights

How Growth Investing Works

As the name suggests, the focus of growth investing is growing an investor’s capital. Investments are made in types of instruments known as growth stocks or through investment in companies which are identified as likely to grow their earnings at a rate that is considered above average for the market and/or the industry.

Growth investing is often referred to as a capital growth strategy as capital gains are the aim of the investors. However, this is not always how the strategy is viewed. Some say that value investing and growth investing are opposites. Value investors are on the lookout for stocks which have an intrinsic value above the level at which they are trading, while growth investors will turn a blind eye to standard indicators which may indicate that a stock is overvalued.

Growth investors will seek stocks in emerging companies which they see as having the potential to take off and evolve into large powerhouses and, if successful, such stock picks can bring impressive returns – and everyone is looking for the next big online start-up or breakthrough invention. This strategy, however, is high-risk, as it brings the potential to invest in companies that never take off and just fade away.

RatgeberbilderArtikel Finanzcharts

Defining Growth Stocks

Put simply, a growth stock is any share in an organisation which is expected to grow its earnings at a rate which exceeds the market average growth rate. They are usually not shares which pay dividends as growth-oriented share models will divert extra profits into the business in order to grow aspects such as capital projects.
A good example of growth stocks would be technology companies, as the potential for growth in this sector is practically limitless. Conversely, this kind of stock carries greater risk because capital gains are dependent on the company’s success in the business world. Should the business fail for any number of reasons – for example:

  • Competitors gaining an advantage
  • Marketing not being as effective as expected
  • Demand for the product falling away

Any of these things happening would likely cause shareholders to experience losses as share prices fall in line with confidence.

While small-cap stocks are often the prime type of growth stocks, not all growth stocks come from small-cap companies. Growth stocks can be those which are based on scale of manufacturing. Mass production methods make unit prices much cheaper than smaller scale operations, so large companies which are taking advantage of the economics of scale can be a ready source of growth due to the profits such a model returns.

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Size Doesn’t Matter

There are a few other features that all growth stocks share regardless of the size of the company. A growth company will either have a strong grip of the market share in its sector or enjoy a customer base with a strong sense of loyalty to the brand or product. This may be because it was the first company to provide a service or product of that kind or that it has a strong reputation for being the best “go-to” in that market segment. A unique position or niche within a sector is a common factor for growth companies and can even be the defining feature.

Growth companies tend to have specialised, unique, innovative or advanced products on offer. Perhaps they hold a patent on an invention or innovative technology. They may dominate a field of research or advancement for a specialised industry. These factors are the same ones that dictate the reason that these kinds of operations do not follow the dividend model. If you are at the cutting edge of a field of research, and profits made need to be re-invested in research and development, diverting money into dividends would only serve to hinder the very advancement that is causing the company to grow.

Assessing a Company’s Suitability

The goal of a growth stock investor is to correctly identify stocks that are either undervalued or merely at a low value but with high potential to grow after emerging. Making such a call is a matter of both subjective and objective judgement on the part of each individual investor and will be dependent on a combination of their knowledge, instincts and life experience. Each individual investor will have a decision-making process that best suits their investment strategy, how much they have to invest and their investment objectives. In addition to the individual investor’s own knowledge, they will usually look at where the company places within its industry and how it is performing, as well as the company’s past performance in the relevant industry. Things to note are:

  • History of the company’s earnings growth since it was founded
  • Estimates for forward earnings growth, usually outlined in the most recent company reports
  • How well the management is controlling costs and revenues
  • The manner in which the management operates the business
  • Whether there is potential for the company to double in value within five years

These are the five factors which will usually have the most influence over an investor’s decision when rating an individual company.

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Assessing Growth Against Value

Looking a little deeper into growth investing, there are two related but distinct types of stocks: true growth stocks and value stocks. Value stocks are those which have the potential for growth due to their being undervalued or underrated. These stocks will be seen as having the potential to create strong capital gains but for one reason or another the market has ignored or underrated them. They are called value stocks because they are undervalued.
The other type of growth stocks are those which have already been identified by the market as having the potential for growth. The problem this creates is that since they are known to have growth potential, they are overvalued, which means growth is a slower process.

So ideally, value stocks are the best ones to look for. They may have issues such as a past record of flat earnings results, legal issues or bad press, but are useful provided you can identify solid fundamentals, decent financial structure and a history of solid overall performance. It is consistency that can be an indicator of good future performance because as a company finds its feet, earnings will start to grow. As long as the company hasn’t been posting persistent losses it is worth looking into.

The best overall strategy is to diversify your portfolio and hold a combination of value stocks and growth stocks to create well-rounded trading strategies.

Look for Trending Sectors

This section of our growth investing guide will cover the art of seeking out hot sectors on which to concentrate. It is reasonably easy to identify the popular sectors. Reading the financial press is a good indicator, as the trending sectors will be the ones that are being written about the most across multiple publications. Always check multiple news agencies for these trends – don’t base your research on just one source.

Keep reviewing which sectors are the movers, as like all trends, this will change over time. What is hot one year may very well have fallen out of favour the next and it is important to check in continually on how your picks are faring. Be prepared to change what stocks you are backing if need be.

For example, healthcare and pharmaceuticals have been strong sectors in the past decade or so, as have tech companies, either web-based businesses – everyone has heard of dotcom stocks – and also the kind of tech companies that produce software and hardware for commercial applications. These are sectors that grow along with advances in technology, and the tradition is that as technology develops, prices for existing technology comes down, enabling more economical use of that technology to create even more advanced technology, so these type of companies have a cumulative effect of driving their own sector. This is a recipe for success in a world that is becoming ever-more technologically reliant.

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Using Exchanged-Traded Funds and Other Derivatives

Growth investing can be simplified with the use of pre-packaged investment vehicles which are created by investment banks or fund management companies. These can take the form of exchange-traded funds (ETFs), mutual funds, mortgage-backed securities and other types of derivatives.

The advantage of this kind of security is that all the research and hard work is done for you. If you become a client of a provider of such products, you are usually able to discuss your requirements with a financial advisor who is essentially a salesman for the company’s investment vehicles. Advisors are there to identify the type of investment strategy you are looking for and match those requirements with the products they have on offer. Depending on the company, this can incur separate broker fees, but in some cases the fees are built into the prices of the instrument. For example, ETFs are popular due to the fact they can be packaged up with low trading costs.

  • An ETF is a tradeable bundle of stocks
  • They are a convenient pre-packaged portfolio
  • For a fee, much of the hard work is done for you

It is important to remember that ETFs are not an easy answer. Just because a company has packaged up a basket of stocks which trade like a single stock, it doesn’t mean they can’t be hit by a volatile market. The possibility of large swings in value of course depends on the underlying assets and this will vary between individual ETFs.

Conclusion:

Growth Investing

While it is a long-term strategy and not a get-rich-quick scheme, growth investing is one of the riskier and more volatile of the stock investing strategies. Choosing the right stock involves a great deal of research and insight into what kinds of companies – particularly start-up companies – are likely to become the next Google. Investors need good business sense and the ability to understand company earnings reports to be able to make educated calls on which stocks are worth taking on board and which are in danger of collapse. There is no foolproof formula and success can be as much the result of luck or circumstances that could not be predicted as the result of skills and ability on the part of the investor.

There is a certain amount of satisfaction that comes from sniffing out an undervalued company, investing, watching it grow, then when it powers ahead, being able to say that you found it before anyone else knew how big it was going to be.

When taking on this kind of strategy, decide how you are going to structure your portfolio and what sort of timeframe you have for investing, and then do your research and keep up with the markets. Taking an active role in the management of your investments will go a long way to ensuring only successful company stocks remain in your portfolio over the long term.

Stocks Highlights

Positives of Dividend Investing

Dividend investing has the potential to grow your portfolio exponentially because of the effect of compounding. Most people have heard of compound interest, and compounding works similarly with dividends. All you have to do is ensure that as dividends become due you either opt for them to be paid in the form of shares or use the dividend proceeds to reinvest in more shares. Over time and the cycle of dividend pay-outs, this has the effect of growing your base, generating more and more wealth, year on year. When making a broker comparison, how dividends are paid is one of the things to check.

There are also dividend stocks that grow year on year, giving them an effect of negating inflation and providing a passive income if you are not in a position to re-invest. Also, if a dividend pay-out falls, it is a sign that the company may be in trouble and can be an exit signal.

Some analysts argue that stocks that pay dividends are more reliable than stocks that merely reflect a company’s value, as should that value fall, all you have is the face value of the stock, and you don’t collect any actual income along the way.

Providing income and beating inflation are both strong arguments in favour of owning dividend shares but there are also reasons why it is not such a good idea.

stocks 3

Negatives of Dividend Investing

While dividends can be a useful source of passive income, there’s the issue of volume against capital. In useable terms, realising any income stream from dividend investing requires a very high-value portfolio, as while relatively low in volatility compared to other financial instruments, dividend shares give quite a low yield, often below 3% per annum. This means that even with the highest returns, to earn a modest income of $30,000 a year, you will need to have $1 million on hand free to tie up in your investment.

While this may not carry the same level of risk as, for example, the property market in a big city, it also carries much lower potential for returns. Given that markets usually recover from property market crashes and real estate inflation can be well into double figures of percentage return, you need to think long and hard before deciding on the best place for your money.
Another factor that makes dividend stocks less attractive is that they have become costly when measured by their price-to-earnings ratio. Also, the very fact that the company has to pay out dividends means they have less capital available to re-invest in the business, in turn saying the business will be just that little bit less profitable than it could have been if it hadn’t paid dividends.

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Seek Safe Investments

Investors usually look to protect their portfolio and mitigate loss as well as chasing profit. One of the elements that dividend investors seek is dividend safety. The primary measure of dividend safety is dividend coverage ratio. This is calculated by dividing the company’s net income by the dividend paid to shareholders. The higher the figure, the safer the company and the more losses it can absorb while still being able to pay a dividend. Low dividends might be an indication of dividend safety provided they are being kept low by a high dividend coverage ratio. A low dividend coverage ratio might mean higher dividend figures, but it gives a small safety margin and can lull investors into a false sense of security. Low ratios indicate the risk is high and one major, unexpected market event can wipe out dividends – and possibly even the company – completely.

Investors should seek out companies that have a stable cash flow rather than just looking for high dividend bottom-line figures. If more money is coming into a profitable business, coverage ratios can be kept higher, reducing the concern that a downturn could cause the loss of a dividend. High ratios mean that company management has a buffer to absorb future losses without having to drop a dividend too drastically.

Look for a High Dividend Growth Rate

Another element which investors need to decide upon when selecting stocks for dividend investing with maximum return is whether to opt for high yield or high growth rate. Both attributes have different roles within an investment portfolio. If your investment plan is geared towards high dividends, it is set up to result in sizeable short-term cash returns. This is often through stocks from slow-growing companies which are experiencing extra cash flow to fund current dividends.

If your portfolio is massive on high dividend growth shares, it means you are invested in stocks that are geared towards paying lower dividends but are in a period of fast growth so that within a few years the increasing dividends will catch up with stocks bought under an immediately high dividend plan. An example would be when Walmart was going through a stage of rapid expansion, and the price-to-earnings ratio was set relatively low so the actual dividends being paid appeared small. However, new outlets were opening so quickly that profits were continually climbing so that an investor who bought and held stocks would end up increasing dividends significantly within a few years. There are rare situations wherein a company’s stocks are paying both a high current dividend and going through high dividend growth. This is usually due to a booming economy, and it is a situation with the potential for substantial long-term performance with a buy-and-hold strategy.

How Companies Decide What Dividends to Pay

It is usually the board of directors who decide what dividend a company will pay, and this is generally etched into the company’s dividend policy. When it comes to calculating dividends, a company needs to consider how much it will spend on repurchasing shares, how much to reinvest, how much of its debt it will pay down and whether it will participate in any mergers and acquisitions. All those factors have a significant influence on what dividends are paid and, in turn, this will govern what type of investors the company will attract. There are several things to remember when it comes to a company’s dividend policy:

  • Their dividends should be quantifiable. Companies with legitimate dividend policies will have clearly defined records of past and estimations of future dividends.
  • Look for a strong history and culture demonstrated within the company reports of striving to return healthy dividends to shareholders.
  • An established policy on dividends will have the effect of ensuring the management is careful with the use of available capital, especially when pursuing deals.

There is an accounting theory that a company’s worth is determined by how much it can pay in dividends. In accountancy, a company’s value is tied to it being able to pay dividends to shareholders at some point. The company must generate revenue for its owners. Otherwise, there is no justification for operating the business in the first place.

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Finding the Right Stocks

It is always possible to identify suitable stocks for your portfolio. However, zeroing in on the ones with the highest dividend can be a bit more difficult. The biggest problem you will encounter is that once you have identified which companies have the stocks with the highest yield, you will also often find that these same stocks come with a catch. Sometimes yields are high because investors are avoiding the stock. This can happen when there is a reason why the dividends are about to be cut due to falling profits, or perhaps the business is in some trouble and may be in danger of going under. Some precautions can be taken against too much exposure to the downside.

  • Ensure the dividend payout ratio is no more than 70%, meaning that the company retains at least 30% of its earnings for expansion and unforeseen events.
  • Look for companies with pricing power. Such companies can offset high inflation rates by increasing their prices accordingly.
  • Stocks should have a debt-to-equity ratio of under 50%, meaning that for every dollar of debt they should have at least a dollar of net worth.

These are just some of the precautions that can be taken to ensure that dividends continue to create passive income for your stock portfolio.

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2
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3
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Deciding Which Companies are Best

Once you have selected from your dividend investing guide that dividend shares are the way to go, you next must determine which specific shares to buy. There is no easy answer to which ones are best for you and it also depends on how active a role you want to take in managing your portfolio.
Aside from the elements mentioned above, there are a few more factors to include in your search for the right stocks:

  • Look for distribution rate over dividend yield
  • Familiarise yourself with the key metrics of a company that interests you
  • Look at the company’s current performance and scan the media for any news surrounding its operations or management

Remember that this investing is a slow and steady process, so you will be able to review and reset your strategy as time passes. There is no need to rush your decision. One more point to remember is to stay away from debt in general. Don’t get into debt to purchase these kinds of lower-yielding instruments, as your dividends and any increase in asset value combined are unlikely to keep pace with interest repayments. You also shouldn’t buy into companies that are saddled with high levels of debt, as repayments will cut into dividend yields.

Conclusion:

Dividend Investing

Investors with a more conservative approach to structuring their portfolios often opt for dividend investing because there is some research showing that this class of instruments will perform better over time than their counterparts, growth stocks. The reasoning is that companies that have a dividend policy force their management to take more care when selecting acquisitions and to allocate capital within company operations, which leads to better company performance.

It must be remembered that Investing in dividend stocks is a slow, steady process that needs years to grow into a profitable proposition. It also requires considerable capital outlay to earn any kind of substantial income. If you are willing to stick at it for years, however, there can be significant payoffs at the end, but such a system requires patience and dedication to make it work. While it is a form of passive income, the return figures are not high, which is why this type of strategy is only suitable for the risk-averse who have other income streams and are looking to lock up more substantial sums of money over the longer term. This type of investing is probably the furthest thing from a get-rich-quick scheme.

Stocks Highlights