Different Strategies for Different Stocks
Have you ever wondered what is the best strategy to use when you enter the stock market?
Short or long term?
Buy-and-Hold and dollar cost average or trend follow?
Use only fundamental analysis or technical analysis?
When is the best time to enter and exit?
Well, this all depends on the kind of stocks that you’re buying. All stocks are different, and they have different characteristics and they behave differently
It will also depend on the objective of buying that stock.
Let’s take a look at the different stock categories available.
DEFENSIVE STOCKS
These are stocks of companies that sell a product or service that is a necessity. They are products or services that you will require even if the economy is in a recession. That is why they will always have consistent sales and profits despite the economic cycle.
These are also known as ‘boring businesses’ with stagnant to moderate growth.
Boring may not be bad – Warren Buffett once said that he loves boring businesses because they are so predictable! That is why they are great for investors who do not mind moderate returns with low volatility.
Defensive stocks also tend to outperform during a recession. If you look back at the previous years’ recessions where the general stock market was collapsing, defensive stocks were going up or sideways. It did not go down because people are still using these products!
The best time to buy defensive stocks is when you’re expecting a recession to hit and last for a while.
At the same time, defensive stocks tend to underperform during an economic boom. When a recession is over and the economy recovers, they are the last ones recover because they move very slowly.
US Sector Stocks (Defensive)
Health Care:
Johnson & Johnson
Pfizer
United Health
Well Point
Abbott Labs
Consumer Staples:
Proctor & Gamber
Walmart
Pepsico
Colgate P.
Coca-Cola
Kimberly Clarke
Utlities:
Duke Energy
Exelon
Nextera
Dominion
Southern Co.
You could buy the individual companies, or you can buy the entire sector’s ETF. When you buy the ETF, you get exposure to all the companies in that sector.
This is how a defensive stock’s chart looks like:
In a 5-10-year horizon, you will notice that the stock goes up in a very clear uptrend with very shallow dips because it’s defensive.
CYCLICAL STOCKS
Cyclical stocks are the opposite of defensive stocks.
They are stocks of companies that sell products/services that are a ‘luxury’ or dependent on the economic situation. As a result, they generate high sales and profits during economic expansion and have lower profits and losses during recessions.
The stock prices are correlated to the health of the economy. Hence it is great for investors who are willing to experience high volatility or higher gains.
They also underperform during a recession and outperform during an economic boom.
That is why you only want to buy cyclical stocks during an economic recovery expansion.
This is how a cyclical stock chart looks like:
Over a 5-10-year horizon, the price looks exactly like a roller coaster ride. In general, you do not want to buy and hold these stocks. For cyclical stocks, you must time your entry using technical analysis.
You only want to buy when the price starts an uptrend and when it’s near the bottom. That is where technical analysis will help you to determine the support and resistance level and the range of the stock.
At the same time, when the stock hits a high, you’ll want to short-sell the stock at the resistance and profit as it collapses down to the support level.
US Sector Stocks (Cyclical)
Consumer Discretionary:
Home Depot
Target Corp
Lowes Cos
Nike Inc
Walt Disney
Time Warner
Technology:
Apple
Google
eBay
Amazon
Microsoft
Industries:
Deer
General Electric
3M
Caterpillar
United Techno
Materials:
Dow Chem
Nucor
Aloca
Du Pont
Monsanto
Energy:
Exxon M
Conoco P.
Chevron
British Petroleum
Finance:
Citigroup
JP Morgan
Bank of America
Goldman Sachs
You can buy individual stocks or the ETF of these sectors.
Among these sectors, I would say that industrials and materials are the most cyclical. Technology would be the least cyclical because we still use technology even when we are hit by a recession.
Let’s get more specific with the 2 different kinds of stocks.
These 2 stocks can be further subdivided into 6 categories and which category to invest in depends on your objective and your needs.
Each category has different characteristics and they behave very differently.
Category 1: Income (Dividend) Stocks
These are specific companies that pay a percentage of their profits out as dividends. Not all companies do this, and these are typically large and mature companies in a slow-growth industry.
The main objective of investing in this is to collect dividends or passive income from the company every quarter of the year.
The special criteria dividend stocks are:
- Dividend yield of at least 4%-5%
- Consistently increasing dividend per share for the last 5 years
- Consistently increasing net income, cash flow from operations for the last 5 years
- Stable share prices (range or trending up) for last 5 years
- The best kind of dividend stocks would be defensive and predictable companies where their product hardly changes (avoid cyclical stocks)
- The company must have conservative debt and one way is to look at their interest cover ratio and you want it to be less than 30%
- You can Dollar Cost Average and Buy and Hold these companies if you want to
Category #2: Large Cap Predictables (Products/services you use regularly)
These are companies that are predictable but the products never change.
These companies also have wide economic moats and predictable earnings and cash flow from operations. Their products/services never go obsolete and tend to be defensive.
They usually have slower but steady capital appreciation. Growth rates are at 5-10% per year.
These are also companies that you can dollar cost average or buy and hold for the long term.
Some examples include Clorox, Colgate, Coca Cola, McDonalds.
If you look at their chart on a long term basis, they make a very clear uptrend with very minor dips along the way.
Category #3: Large Cap Growth
These are mature, large companies that still have high growth potential (>25%). As a result of the high growth, their price is usually near/slightly above intrinsic value (priced at a premium) and they are usually on a steep uptrend and tend to fall drastically once the growth slows down.
They are risky to buy and hold. You never want to buy and hold a growth company because all the huge profits will eventually disappear. You should buy on uptrends and exit on downtrends.
Some examples are Facebook, Amazon, LinkedIn, Netflix, PriceLine
Category #4: Deep Cyclicals
These are companies that are highly capital intensive industries and have the inability to respond to demand changes quickly. But they make huge profits when the economy is doing well.
Some examples are real estates, finance, offshore & marine and commodity companies
The price of a deep cyclical stock looks like a roller coaster; hence it is highly risky to buy and hold.
You should buy when stock is near the bottom of their cycles. When the price is highly undervalued or selling below book value and reversed into an uptrend.
You should sell when the stock is at the top of the cycle and just reversing into a downtrend.
Category #5: Turnarounds
These are companies whose stocks have been beaten down by temporary bad news. Avoid stocks that are hit by financial scandals.
As a result of these scandals, the stock price is usually way below the intrinsic value and it is best to enter when the price has resumed its uptrend.
Some examples are banks after the end of the financial crisis, Apple (when Steve Jobs died), Yum Brands (when they faced difficulty in China because they used expired meat products)
Category #6: Fast Growers
These are small to medium companies that grow at least 25% a year. There’s also the possibility of very high returns if these small-cap stocks turn into medium or large caps.
They are also riskier as not all small caps will survive because they tend to have narrow economic moats and potential cash flow problems. When you buy these companies, you must be more stringent on their conservative debt and healthy cash flow.
Some examples are Amba, Noah Holdings, Globant SA
Now that you are clear that different kinds of stocks require different kinds of strategies, I am sure you will make your own decisions based on the stocks and strategies you are looking at. May the markets be in your favor.
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