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Common Stock Strategies Part 2: Quality, Income, Cost Averaging

By: , dated January 25th, 2013

Warren Buffett and Quality

Some investors prefer to consider themselves not ‘value’ or ‘growth’ but ‘quality’. This is a sort of hybrid approach in which the investor is searching not for questionable companies at bargain prices or exceptional companies at outrageous prices, but good companies at good prices. This strategy relies on a combination of quantitative and qualitative factors.

Warren Buffett is often cited as a classic example of a quality investor. Buffett relies on a fairly simple investment strategy that can benefit any investor interested in identifying good values. He looks for great stocks, then buys them and holds them for several years or more. Buffett is a long term investor who plans to hold onto stocks for many years from the time of purchase. He thinks of his investment as buying a piece of a business, not just shares of its stock. In this sense, the management of the underlying company is an important criterion in the investment decision.

Buffett determines the value of a business by totaling the net cash flows he expects to occur over the life of the company and discounting them by the appropriate interest rate. He may add a premium based on the risk involved in the particular investment. He focuses on return on equity, operating margins, debt levels and capital expenditures to identify the best investments.

Interestingly, Buffett challenges some of traditional notions regarding diversification. He believes that diversification is less necessary for those able to confidently choose a select number of stocks they are confident will significantly outperform the market. For him, identifying a few good values is far more important than spreading invested money across a typical diverse portfolio.

Income

Income investors practice a very straightforward strategy: they buy stocks with the highest dividends. Income investors focus primarily on securing a steady income stream, instead of worrying about capital gains (although they obviously hope that the shares will increase in value). The stocks of large, well-established companies usually qualify as income stocks. Income investing is one of the more conservative stock strategies, yet there are still the usual risks involved in investing in equities. In some respects, this strategy is closer to bond investing than stock investing, even when stocks are used.

Dollar Cost Averaging

Dollar cost averaging is a good strategy for beginners that involves regular contributions of a fixed dollar amount to a portfolio or specific investment. At each interval, the chosen amount is invested, removing any emotional motivation to react to short-term changes in the value of the investment. Of course, dollar cost averaging does not guarantee a profit, but it does encourage consistent investing and prevents short-term movement from leading investors to make emotion-based decisions that could harm their long-term strategy.

Because the investment is purchased at a range of prices over time, fluctuations in price are evened out and the initial price has a far smaller impact on the returns at the time the investment is sold. The average price paid trends toward the current price at each interval. As a result, the gap between the value of the money paid in and the current value of the investment decreases. However, the average price does not move fast enough to completely eliminate the possibility of profit or loss. Although dollar cost averaging can prevent a large negative gap from growing between the price paid and the current price, it limits the potential for a positive gap in the same way.

Essentially, dollar cost averaging is ideal for investors who wish to eliminate the risk associated with timing the price of an investment and reacting to short-term results at the expense of limiting themselves to a decidedly conservative strategy. Some investors believe dollar-cost averaging is most effective when a stock is underperforming because more shares can be acquired for the same regular investment amount. However, better performance is not guaranteed and that aspect should not be the primary motivation for adopting this strategy.

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