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A Trader's Weapons Of Value & Growth

08/14/12 09:13:27 AM
by Billy Williams

For a trader, price and strategy are key components for successful trading when properly combined with both the value model and growth model approach to higher gains.

Security:   CLB, ALXN
Position:   Hold

In the investing world, the debate over whether a value model approach or a growth model approach will yield greater returns over a stretch of time has been a heated discussion among investors and fund managers. Each side can present an endless stream of data and Excel spreadsheets that can make a sound and rational argument why one approach is superior to another. However, from a trader's perspective, both sides miss the mark when it comes to pinpointing the key factor in determining superior returns that is matching strategy to market type.

First, understand the essential aspects of each type of approach. In a value model, the strategy is to find assets that are currently trading below their intrinsic value. In the most simplest terms, it's trying to buy $1 for 50 cents and keep repeating that process. Benjamin Graham, the founding father of this approach, would evaluate companies that were trading far below their net asset value and buy as many of the companies as possible with no consideration of their current earnings or the quality of those earnings. And when the stock rose 50%, he would sell immediately.

FIGURE 1: CLB. CLB was a high-performing stock leading into 2008 when the bear market dropped it below its net asset value and offered ripe pickings for traders using a value model approach. As the market recovered, CLB continued to rise up to its former highs, where growth-model traders were able to ride the momentum higher during the bull market in force at the time.
Graphic provided by:
It was a simple approach and despite its application during a turbulent time -- in the 1930s and 1940s -- Graham managed to average a respectable average 17% return.

While there are numerous factors that you could also consider as well, the merit of the value model is sound and reliable in and of itself.

In the growth model, earnings power is the lifeblood of this approach, so the idea is to spot companies that have accelerated earnings and rising sales revenue that we could presume is to self-finance its growth. Specifically, it's the rise in the company's earnings power that attract investors who assume that that earnings power will express itself in the stock's value.

FIGURE 2: ALXN. Traders using the growth-model approach to trading witnessed ALXN's resistance to the downward pressure presented by the bear market in 2008 and the following year, only to emerge as a stock leader as bulls took command of the market, causing ALXN to almost quadruple in price.
Graphic provided by:
The entry is triggered as price trends higher and comes out of a price base using an all-time price high or chart pattern such as the cup & handle as the setup. See Figures 1 and 2.

Where each camp of advocates miss the mark is that each approach is limited to the context of the market at any particular time. For example, using a growth-model approach in a bear market is pointless because there is no momentum or strength to drive prices higher. However, the downward pressure by a bear market can be a blessing for the value-model approach because even good companies that are fundamentally strong will be affected and their stock price driven below their net asset value.

Conversely, if a bull market is in place, both value and growth stocks will rise but investors using the growth-model approach will excel in this environment because their accelerated earnings will attract investors while having the added benefit of momentum being on their side.

But for value-model investors, new opportunities to buy more stocks will be limited as stocks trade up to or beyond their value with many stocks even trading beyond a fair valuation, making this approach rather fruitless for investors using this approach in this market type.

For traders, though, each model is viewed as a means to achieve an objective -- higher returns. And rather than be married to a given approach, you are more likely to be moved to customize it to meet your objectives by using it in an arena where its most effective traits can be used to maximum effect. Like a general, models and methods are like tools of war that you dispatch where you can yield the most return with the least risk, and using these two reliable methods, you have extremely effective weapons to reach your objectives, provided you use the right strategy with the right market type.

Billy Williams

Billy Williams has been trading the markets for 27 years, specializing in momentum trading with stocks and options.

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