Active investors combine fundamental and technical analysis, moving in and out of the market in accordance with the phases of the business cycle.
The major differences between active investing and trading are:
- A longer time frame;
- Increased emphasis on value;
- Risk diversification; and
- Stop-losses set with higher loss limits, because of the emphasis on value and diversification.
The most influential author in the active investing field is William J O'Neil, author of How to Make Money in Stocks and 24 Essential Lessons for Investment Success.
Active investing emphasizes fundamental stock values, comparing earnings prospects to the current market price:
- Does management have sizable stock holdings?
- Do employees have a real stake in the business? Normally in the form of options or profit-sharing arrangements.
- Examine the company's products or services:
Does the company have a competitive edge? Do they have better technology, stronger brands, copyrights, patents or greater expertise that gives them an advantage over their competitors?
- Have sales and earnings per share grown strongly over the past 3 to 5 years?
- Has there been consistent growth in dividends?
This is a good indication that the company is generating cash flow and not just paper profits.
- Have sales and earnings per share growth accelerated in recent quarters?
- Be on the alert for cost reductions and layoffs that may enhance short-term performance at the expense of long-term growth.
Compare earnings prospects to the current price. The PEG Ratio is a handy formula:
Divide the current Price-Earnings Ratio by the expected long-term growth rate (in earnings per share).
- A PEG ratio less than 1.0 signals a buy opportunity.
- Ratios of 0.5 or less are strong buy signals.