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Which Is Better, Trading Or Investing?
Education | 18 March 2010
By: Ernest Lim
Articles (134) Profile

Are there are any stocks to speculate with a 1 – 3 months horizon? How about stocks to buy and hold for up to 2 years? Any recommendations? These are some of the queries, which are posed by readers and friends.

It is noteworthy that the above questions represent two different approaches and views on the stock market. Before I point out some “tips” for the two approaches, I would like to draw readers’ attention to their differences, which are tabulated below.

Table 1
Differences between the two approaches (Source: Ernest): Table 1

Having appreciated the differences, I will now elaborate on the criteria to pick stocks for trading, as well as, buy and hold approaches.

Criteria to pick stocks for trading purposes

Presence of near term re-rating catalysts

There should be presence of re-rating catalysts in the near term. An excellent example would be dual listing. Typically, this should provide at least a short term boost to share prices, especially if companies are sound and are trading at price to earnings ratio lower than their counterparts in the stock exchange which they are going to list. Z-Obee is a case in point where its share price more than tripled since its announcement on dual listing.

Secondly, the industry in which the companies are operating in should be growing at phenomenal rates. It would be better if the companies’ peers are reporting better than expected results. This would increase the possibility of earnings surprise for the companies for this quarter and upside guidance for the coming quarter from the companies, spurring a re-rating of share prices. To be clear, the industry should be growing at phenomenal rates and not sustainable rates. Thus, it is not required to find companies which are growing steadily at 10% a year, but is required to find companies which are growing at least 30% y-o-y for the current quarter and next quarter.

Thirdly, if one is aware of the contracts bidding from the companies, one should be able to estimate when the contract wins would be announced. If I take Swiber as an example, an investor who is familiar with it should know that Swiber’s contract awarding period in South Asia and Southeast Asia is usually around Dec to Mar. Couple this with the improvements in the oil and gas industry, one should not be too surprised that Swiber announced a string of contracts during that period. Nevertheless, there is a fair level of risk in this prediction.

Fourthly, for companies with blockbuster products which are expected to have significant contribution in the near term may also be considered as stocks for trading purposes. These companies have the potential to enjoy a significant boost to earnings which may result in an upwards re-rating of shares.

Propaganda on the stocks

If readers want to trade, then a prerequisite would be to choose stocks which have propaganda. Examples of such would be plant visits and road shows where fund managers and analysts can get to know the company and company management better. Analysts typically will write analyst reports or some internal notes after such visits. Stocks which are good to trade should also have some “stories or some attention catching ideas” to excite the investment community. An example of such stock is KS Energy where it soared multiple folds when it announced that it would modify its business model from being solely a distributor of consumable oil parts to a rig refurbisher in 2005.

Technicals

This is a colossal topic to discuss here. Suffice it to say that the charts should look strong, indicators well placed, and price movement confirmed with volume and price action. As a result, traders may buy the stock at a relatively high price (as measured by valuation metrics such as high PE ratio against the peers) and sell it higher.

Criteria to pick stocks for investing purposes

For investors who are looking to buy and hold with a horizon of up to 2 years, it would be good to consider the following points:

Competent management – necessity for buy and hold

Management should be competent so as to manage the company well over the medium to long term. Over the short term, management competency can be masked by non recurring items such as executing seemingly earnings accretive acquisitions which boost the company’s results in the short term, or create propaganda so as to create interest in the stock. However, only time will tell whether these actions create shareholder value. Thus, if readers want to buy and hold over a longer period of time, it is pertinent to find a company managed by competent management.

Sustainable earnings and outlook

For this strategy, it is a prerequisite to find companies with predictable financial performance. To have predictable performance, the companies should have the following characteristics.

Firstly, the companies should operate in industries which are growing steadily. They should not be in industries with limited visibility or in cyclical industries. For example, the foundry companies typically have limited visibility and it would be wise to avoid them with a buy and hold strategy. In 2007, the automotive companies’ shares soared at the top of the industry cycle but subsequently fell due to over supply of wheels and lack of demand. Therefore, it is best to avoid industries with limited visibility or in cyclical industries.

Secondly, besides having a stable growing industry, it is important to buy companies whose earnings are predictable due to their business model. Companies whose earnings gyrate widely due to changes in demand should be avoided as these companies involve more monitoring and attention to hold this kind of shares. Nonetheless, if readers can determine that the companies’ lackluster results are once off and they are likely to post better results for the next few quarters, readers can still consider to invest in these companies.

Margin of safety

Buy and hold is typically a more conservative strategy than trading. Thus, it is important to reduce risk by having a good entry price, so as to have a good margin of safety. This is one of the tenets which Benjamin Grahman advocates.

Dividend yield

This is a good criterion to have as it generates income while holding your stocks till they reach your target price. In addition, it creates at least some incentive to continue holding while some of your friends may have obtained quick gains (as well as losses) in the market.

Conclusion – which approach is better?

To decide which approach is better, it depends on the horizon that one has. Different strokes for different folks so which approach suit you? It’s up to the individual reader to decide.

1 For the purpose of this article, buy and hold is synonymous with investing and entails a horizon of 4 months to 2 years. 2 years were chosen as there is considerable difficulty to predict beyond 2 years for the average retail investors.

Ernest Lim is a CFA, CA and has worked at GIC Special Investment. He has a solid feel of the markets and financial world and is now a remisier.

Please click here for more information about this author.


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