Category Archives: Value Investing

Investing Principles and Rules

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Value investing is one of the most preferred ways to find strong companies and buy their stocks at a reasonable price in any type of market.

Value investors, such as Warren Buffett and Monish Pabrai, use fundamental analysis and traditional valuation metrics like intrinsic a value to find companies that they believe are being undervalued intrinsically by the stock market.

A stock is not just a ticker symbol; it is an ownership interest in an actual business with an underlying value that does not depend on its share market price.

Inflation eats away at your returns and takes away your wealth. Inflation is easy to overlook and it is important to measure your investing success not just by what you make, but by how much you keep after inflation. Defenses against inflation include:

  • Buying stocks (at the right prices),
  • REITs (Real Estate Investment Trusts), and
  • TIPS (Treasury Inflation-Protected Securities).

The future value of every investment is a function of its present price. The higher the price you pay, the lower your return will be.

No matter how careful you are, the one risk no investor can ever eliminate is the risk of being wrong. Only by insisting on a margin of safety  – by never overpaying, no matter how exciting an investment seems to be – can you minimize your odds of error.

Knowing that you are responsible is fundamental to saving for the future, building wealth and achieving financial freedom. It’s the primary secret to your financial success and it’s inside yourself. If you become a critical thinker and you invest with patient confidence, you can take steady advantage of even the worst bear markets. By developing your discipline and courage, you can refuse to let other people’s mood swings govern your financial destiny. In the end, how your investments behave is much less important than how you behave.

Every investment is the present value of future cash flow. Everything Money

Three things to know is that it’s important to understand and acknowledge that a stock is a piece of a business. Thus, it becomes essential to understand the business..

  • Principle #1: Always Invest with a Margin of Safety – Margin of safety is the principle of buying a security at a significant discount to its intrinsic value, which is thought to not only provide high-return opportunities but also to minimize the downside risk of an investment. No matter how careful you are, the one risk no investor can ever eliminate is the risk of being wrong. Only by insisting on a margin of safety  – by never overpaying, no matter how exciting an investment seems to be – can you minimize your odds of error.
  • Principle #2: Expect Volatility and Profit from It – Investing in stocks means dealing with volatility. Instead of running for the exits during times of market stress, the smart investor greets downturns as chances to find great investments. The guru of value investing Benjamin Graham illustrated this with the analogy of “Mr. Market,” the imaginary business partner of each and every investor. Mr. Market offers investors a daily price quote at which he would either buy an investor out or sell his share of the business. Sometimes, he will be excited about the prospects for the business and quote a high price. Other times, he is depressed about the business’s prospects and quotes a low price. The market is a pendulum that forever swings between unsustainable optimism (which makes stocks too expensive) and unjustified pessimism (which makes them too cheap). The intelligent investor is a realist who sells to optimists and buys from pessimists.
  • Principle #3: Know What Kind of Investor You Are – Graham advised that investors know their investment selves. To illustrate this, he made clear distinctions among various groups operating in the stock market.1 Active vs. Passive Investors Graham referred to active and passive investors as “enterprising investors” (requires patience, discipline, eagerness to learn, and lots of time) and “defensive investors.”1 You only have two real choices: the first choice is to make a serious commitment in time and energy to become a good investor who equates the quality and amount of hands-on research with the expected return. If this isn’t your cup of tea, then be content to get a passive (possibly lower) return, but with much less time and work. Graham turned the academic notion of “risk = return” on its head. For him, “work = return.” The more work you put into your investments, the higher your return should be.

Because the stock market has the emotions of fear and greed, the lesson here is that you shouldn’t let Mr. Market’s views dictate your own emotions, or worse, lead you in your investment decisions. Instead, you should form your own estimates of the business’s value based on a sound and rational examination of the facts.

References:

  1. https://www.investopedia.com/articles/basics/07/grahamprinciples.asp
  2. https://jsilva.blog/2020/06/22/intelligent-investor-summary/

A Stock’s Price vs. a Company’s Intrinsic Value

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“Stock prices fluctuate unpredictably.  But company values stay relatively steady.” Kenneth Jeffrey Marshall,

Value investing is one of the most popular ways to find great stocks in any market environment. Value investing represents an approach to investing, where investors evaluate the fundamentals or intrinsic values of companies rather than estimating the future market prices of stocks. The definition of a value stock, for our purposes, is a stock that is underpriced by the market or due to volatility relative to its worth or fundamentals.

Value investing is about finding stocks that are either flying under the radar and are compelling buys, or offer up tantalizing discounts when compared to fair value (or intrinsic value). According to Investopia, intrinsic value is a measure of what an asset is worth. In short, it’s the underlying value of a company and its cash flow.

The idea of value investing involves purchasing great stocks of companies priced by the market well below their intrinsic values, which can give investors a margin of safety. The margin of safety comes from buying good companies at cheap prices. It comes from buying good companies that you understand, and to do so at a discount to companies estimated intrinsic value. That discount is where the margin of safety comes from.

Great stocks shouldn’t get cheap. But sometimes they are.

Value investing also allows traders to detach from their emotions of fear and greed when stock prices fluctuate. It enables them to hold the stocks for long-term rather than buying and selling if they’re feeling wildly optimistic or pessimistic because of stock price and market volatility.

Price and value differ:

  • Price is what something can be purchased or sold for at a given time. Price fluctuates.
  • Value is what something is worth, it fluctuates less.
  • Identify the right price at which to buy stock
  • Hold quality stocks fearlessly during market swings

Value investors understand that over time, the market price of a stock will converge with its actual fundamental worth or intrinsic value. But at a single point in time, it may not. And those single points are enough to purchase good companies cheap or below its intrinsic value.

Value investors also understand that there always comes a time when glamorous businesses stop getting priced like rock stars, and start getting priced like businesses.

Over time, the average price of an asset does converge to the average worth of that asset. But in the short term they can be wildly different, since stock prices fluctuate unpredictably.  But company values stay relatively steady.  This insight is the basis of value investing, according to Kenneth Jeffrey Marshall, author of the investing book, “Good Stocks Cheap: Value Investing with Confidence for a Lifetime of Stock Market”.

The occasions when a stock price is far away from a company’s intrinsic value is when a patient value investor acts.

Value investing is buying companies for less than they’re worth…their intrinsic value. According to the Kenneth Jeffery Marshall, professor, value investor, and the author of “Good Stocks Cheap”, best value investing procedures to utilize include:

  • Do you understand the company
  • Is it a good company:
    • Has it been historically good
    • Will it be good in the future
    • Is it shareholder friendly
  • Is the stock price cheap or at what price will the company’s stock become cheap (margin of safety)

The secret of successful investing: Staying invested and patience. Stock prices can be volatile and can fluctuate unpredictably in the short term.  But the intrinsic values of companies stay relatively steady. Thus, you should chose to invest in companies selling for less than they are worth (intrinsic value) and not over pay for a company.

One way to find companies is by looking at several key metrics and financial ratios, many of which are crucial in the value stock selection process. There are several key metrics that value investors look at, which include:

  • Price to Earnings Ratio (PE). PE shows you how much investors are willing to pay for each dollar of earnings in a given stock. The best use of the PE ratio is to compare the stock’s current PE ratio with: a) where this ratio has been in the past; b) how it compares to the average for the industry/sector; and c) how it compares to the market as a whole.
  • Price/Sales ratio. P/Sales compares a given stock’s price to its total sales, where a lower value is generally considered better. This metric is preferred more than other value-focused ones because it looks at sales, something that is far harder to manipulate with accounting tricks than earnings. The best use of P/S ratio to compare it to the S&P 500 average. Also, you can evaluate the trend of the stock’s P/Sales over the past few years.
  • Price/Earnings to Growth ratio (PEG). PEG ratio is another great indicator of value. PEG ratio is a stock’s price-to-earnings (P/E) ratio divided by the growth rate of its earnings for a specified time period. The PEG ratio is used to determine a stock’s value while also factoring in the company’s expected earnings growth, and it is thought to provide a more complete picture than the more standard P/E ratio. A lower PEG may indicate that a stock is undervalued.

The reality is that some of your selected stocks will lose money. That’s why it is important to diversify your investments, so that losses in a stock may be outweighed by gains in other stocks.

Strength of value investing

Deep value factors, such as book-to-price or tangible book-to-price, usually rally first, when actual levels of rates are still low, says Boris Lerner, Global Head of Quantitative Equity Research. Other value factors, such as earnings yield or free-cash-flow yield, tend to pick up later, as rates rise above trend.

Rising interest rates are the primary reason value investing has staying power. When inflation and rising interest rates are trending higher, it can clip the wings of pricey growth stocks, whose valuations are predicated on future returns, which make pricier growth stocks less appealing. When rates go up, it instantly raises the bar on far-out profits needed to justify today’s stock prices.

Because value names are typically mature companies with valuations based on current cash flow, rising rates don’t have the same impact. At the same time, many traditional value sectors, such as financials, directly benefit from rising rates.

Put the strength of value investing to work for you. In a nutshell, the basic tenet of value investing is paying less for a company than its worth.

  • References:
  1. https://growthwithvalue.com/wp-content/uploads/2020/12/Good-Stocks-Cheap-Book-Summary.pdf
  2. https://finance.yahoo.com/news/10-cheap-value-stocks-buy-140144393.html
  3. https://www.entrepreneur.com/article/397977
  4. https://www.morganstanley.com/ideas/value-stocks-forecast-2021
  5. https://www.gurufocus.com/news/949267/interview-holding-stocks-forever-with-professor-kenneth-jeffrey-marshall

Kenneth Jeffrey Marshall teaches value investing in the Masters in Finance program at the Stockholm School of Economics in Sweden, and at Stanford University. He also teaches asset management in the MBA program at the Haas School of Business at the University of California, Berkeley. Marshall is a past member of the Stanford Institute for Economic Policy Research; he taught Stanford’s first-ever online value investing course in 2015. He earned his MBA at Harvard Business School.

Margin of Safety

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“If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger the margin of safety you’d need. If you’re driving a truck across a bridge that says it holds 10,000 pounds and you’ve got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay; but if it’s over the Grand Canyon, you may feel you want a little larger margin of safety.” Warren Buffett

Billionaire investor Warren Buffett, Chairman and CEO, Berkshire Hathaway, said, “The three most important words in investing are margin of safety.” Margin of Safety is a measure of how “on sale” a company’s stock price is compared to the true value of the company. You need to be able to determine the value of a company and from that value determine a “buy price”. The difference between the two is the margin of safety.

Effectively, margin of safety means you pay less for an asset than what it’s intrinsically worth. It means to buy $10 dollar bills for $5 dollars. That’s the secret to great and successful investing. The margin of safety is the difference between the intrinsic value of a stock and the current market price of the stock. The intrinsic value of an asset is its actual value, that is, the present value of the asset found by calculating the total discounted future income it’s expected to generate.

The intrinsic value is calculated based on the 10 year discounted free cash flow (DFCF).

In other words, if the stock price of a company is below the actual value of the free cash flow (income) and assets of a company, the percentage difference is the Margin of Safety.  This is the discounted price at which you are buying a share in the company.

A higher margin of safety will reduce your investment risk. If an investor can buy a stock below its intrinsic value, the potential for a bad outcome, risk, is usually lower.

Warren Buffett likes a margin of safety of over 30%, meaning the stock price could drop by 30%, and he would still not lose money. Margin of safety is only an estimate of a stock’s risk and profit potential.

Buffett determines margin of safety by estimating the current and predicted earnings from a company from today and for the next ten years.  He then discounts the cash flow against inflation to get the current value of that cash.  This is the Intrinsic Value of the company. He bases intrinsic value on the discounted future free cash flows. He believes cash is a company’s most valuable asset, so he tries to project how much future cash a business will generate.

Margin of Safety is a value investing principle strategy. If the total value of all shares of a company is 30% less than the intrinsic value of that company, then the margin of safety would be 30%. In other words, if the stock price of a company is below the actual value of the cash flow and assets of a company, the percentage difference is the Margin of Safety.  This is the discounted price at which you are buying a share in the company. Most value investors believe that the higher the margin of safety, the better.  In reality, a margin of safety between 30% and 50% is reasonable.

The Margin of Safety is the percentage difference between a company’s Fair Value per share and its actual stock price. If a company has profits and assets that outweigh a company’s stock market valuation, this represents a Margin of Safety for the investor. The higher the margin of safety, the better.

Margin of safety is only an estimate of a stock’s risk and profit potential. Most value investors believe that the higher the margin of safety, the better.  And, the larger the margin of safety, the more irrational the market has become. 

One of the keys to getting a great margin of safety is to understand that price and value is not the same thing. Price is what you pay for something, but the value is what you get.

The stock market rises about four out of every five years or about 80% of the time, according to Nick Murray. Said another way, the market only falls 20% of the time. You can fear that 20% or cheer for it.

No one ever got wealthy paying full price or top dollar for financial assets, according to Buffett. Most successful investors got that way buying assets that were distressed, out of favor, and therefore on sale. Unfortunately, few people see it that way. You need to take advantage of the sale during market selloffs and corrections when it occurs. Your money literally goes further because you can buy more share at lower prices that lead to market-beating returns later on.

If you want to make good long-term investment returns, you need to minimize your risk by purchasing companies selling at a significant discount to their intrinsic value due to market volatility. 

References:

  1. https://novelinvestor.com/10-lessons-learned-nick-murray/
  2. https://www.ruleoneinvesting.com/blog/how-to-invest/how-to-invest-margin-of-safety-the-growth-rate/
  3. https://www.liberatedstocktrader.com/margin-of-safety/

Valuing a Company | Motley Fool

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The most common way to value a stock is to compute the company’s price-to-earnings (P/E) ratio. The P/E ratio equals the company’s stock price divided by its most recently reported earnings per share (EPS).

You can calculate it two different ways, by:

  • Taking the company’s market cap and dividing it by net income – or,
  • Dividing a company’s current stock price by earnings per share

You’ll wind up with the same number either way because in the share price approach, both numbers have already been divided by the total number of shares the company has outstanding. So it’s two different ways to the same place.

A low P/E ratio implies that an investor buying the stock is receiving an attractive amount of value.

You’ll usually see the P/E ratio quoted two different ways:

  • Trailing twelve month (TTM) – which looks at the company’s actual income over the past twelve months.
  • Forward – This approach takes analyst estimates of earnings expectations for the upcoming year and using that as the earnings figure.

If a company is growing, its forward P/E ratio will always be smaller than its trailing twelve month P/E ratio, because more income is expected and the denominator will be larger. If you see a P/E ratio out in the wild and it isn’t specified which kind it is, you can probably assume it’s based on the company’s trailing twelve month earnings.

The P/E ratio only works if there’s an E – or earnings. So it’s a helpful tool for companies that have income, but it’s totally useless if a company isn’t currently profitable. That’s why investors also use another tool for unprofitable companies, the P/E ratio would return a negative number, which really wouldn’t be very helpful, so instead investors use the price to sales ratio.

Price-to-sales is a company’s market cap divided by its total sales over the past twelve months. Because the P/S ratio is based on revenue instead of earnings, this metric is widely used to evaluate public companies that do not have earnings because they are not yet profitable.

High growth software companies can have price-to-sales ratios of over 10, while more established businesses are usually in the mid to low single digits. The P/E and P/S ratios are great because they allow you to normalize companies of different sizes and immediately get a sense of what investors are willing to pay for a piece of that company’s earnings or revenue.

You can use these ratios to compare how a company stacks up to the overall stock market, peers in their industry, or itself relative to the past. Generally, businesses that are posting high growth rates are going to have higher price-to-earnings and price-to-sales ratios. That’s because investors expect that company to be considerably bigger in the future, and they have bid up shares to reflect that. That doesn’t mean that they’re bad stocks to own, it just means that people are expecting big growth to continue and if it doesn’t, shares could fall dramatically.

Conversely, stodgy old businesses in crawling industries tend to have lower p/e ratios because they aren’t growing very quickly – for them this year’s earnings will probably look a lot like last year’s earnings. The market isn’t expecting much from stocks with low valuations, so if the outlook gets worse, they’re less likely to take a huge hit, but they’re also less likely to give investors huge returns.

All you’re trying to do with valuation is to get a sense of how much you have to pay for a dollar of earnings or revenue from a company, and what the market expects of that company.

You can look at to see how a company’s valuation compares to the growth the company is posting. The PEG ratio accounts for the rate at which a company’s earnings are growing. It is calculated by dividing the company’s P/E ratio by its expected rate of earnings growth.

Most investors use a company’s projected rate of growth over the upcoming five years, you can use a projected growth rate for any duration of time. Using growth rate projections for shorter periods of time increases the reliability of the resulting PEG ratio.

The generally accepted rule is that a PEG ratio of 1 represents a “fair value” while anything under 1 is cheap and anything over 1 is expensive compared to the growth the company is posted.

For all these ratios there aren’t absolutes, just guidelines.

As investors we’re looking for quality companies with good business models and exciting growth prospects — it’s worth paying a premium for companies like that, these metrics help us understand what the premium looks like and how it fits into the company’s growth story.

References:

  1. https://www.fool.com/investing/how-to-invest/stocks/how-to-value-stock/

Price-to-Free Cash Flow Ratio (P/FCF)

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Free Cash Flow (FCF) – The cash left after making investments in capital assets

The price-to-free cash flow ratio (P/FCF) is a valuation method used to compare a company’s current market share price to its per-share free cash flow.

Free cash flow (FCF) measures a company’s financial performance. It measures how much cash a business can generate after accounting for capital expenditures such as buildings or equipment. In other words, FCF measures a company’s ability to produce what investors care most about: cash that’s available to be distributed in a discretionary way.

FCF is calculated with the formula below:

Free Cash Flow = Operating Cash Flow (CFO) – Capital Expenditures

Most information needed to compute a company’s FCF is on the cash flow statement. As an example, let Company A have $22 million dollars of cash from its business operations and $6.5 million dollars used for capital expenditures, net of changes in working capital. Company A’s FCF is then computed as:

FCF = $22 – $6.5 = $15.5m

Free cash flow relies heavily on the state of a company’s cash from operations (CFO). The cash from operations deals with the cash inflows and outflows directly related to the company’s primary activity: selling a good or service. Cash from operations is heavily influenced by the company’s net income (excluding depreciation).  

The presence of free cash flow indicates that a company has cash to expand, develop new products, buy back stock, pay dividends, or reduce its debt. High or rising free cash flow is often a sign of a healthy and growing company that is thriving in its current environment.

For investors, free cash flow measures a company’s ability to generate cash, which is a fundamental basis for stock pricing. This is why some people value free cash flow more than just about any other financial measure out there, including earnings per share or book value per share.

Investors should understand that companies can manipulate their free cash flow by lengthening the time they take to pay the bills (preserving their cash), shortening the time it takes to collect what’s owed to them (accelerating the receipt of cash), and putting off buying inventory (preserving cash). Also, companies have some leeway about what items are or are not considered capital expenditures, and the investor should be aware of this when comparing the free cash flow of different companies.

Since FCF has a direct impact on the worth of a company, investors should hunt for companies that have high or improving free cash flow but low correlated market share prices.

Low P/FCF ratios typically can mean the shares of the underlying company are undervalued. Thus, the lower the P/FCF ratio, the “cheaper” and better value the stock remains. 

The best, most successful investors are continually learning and continually honing and expanding their skills at making money in the financial markets.

References:

  1. https://investinganswers.com/dictionary/p/price-free-cash-flow-ratio-pfcf
  2. https://corporatefinanceinstitute.com/resources/knowledge/valuation/what-is-free-cash-flow-fcf/
  3. https://investinganswers.com/dictionary/f/free-cash-flow

Return on Equity (ROE)

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Return on Equity provides insight into how efficiently a company’s management is using financing from equity to operate and grow the business.

Return on Equity (ROE) is the measure of a company’s annual return (net income) divided by the value of its total shareholders’ equity. It is a simple metric for evaluating investment returns and it brings together the income statement and the balance sheet, where net income or profit is compared to the shareholders’ equity.

“ROE is a way to think about how much money you are getting back from an investment,” says Mike Bailey, director of research at FBB Capital Partners in Bethesda, Maryland

The number (ROE) represents the total return on equity capital and shows the firm’s ability to efficiently turn equity investments into profits. To put it another way, it measures the profits made for each dollar from shareholders’ equity.

It is a ratio that investors can use to compare firms operating within the same industry to assess which one presents better investment opportunities.

Comparing ROE for different companies in the same industry helps investors to see which ones have generated the highest rate of return. ROE is a useful metric for service-based businesses.

A sustainable and increasing ROE over time can mean a company is good at generating shareholder value because it knows how to reinvest its earnings wisely, so as to increase productivity and profits. 

“ROE tells you how good or bad management is doing with your investment,” Bailey says. “Higher ROEs generally stem from profitable businesses that enjoy competitive advantages within a given industry.”

In contrast, a declining ROE can mean that management is making poor decisions on reinvesting capital in unproductive assets.

In short, Return on equity measure, of how efficiently a company is using shareholders’ money. Efficient companies tend to be more profitable companies, and more profitable companies tend to make better investments, investors like companies with higher ROEs.

For capital-intensive businesses that require a larger investment in assets, like those in manufacturing and telecommunications, return on invested capital (ROIC) is a more useful measure, as it takes into account their capital expenditure.

Return on Invested Capital is calculated by taking into account the cost of the investment and the returns generated. Returns are all the earnings acquired after taxes but before interest is paid. The value of an investment is calculated by subtracting all current long-term liabilities, those due within the year, from the company’s assets.

The cost of investment can either be the total amount of assets a company requires to run its business or the amount of financing from creditors or shareholders. The return is then divided by the cost of investment.

References:

  1. https://corporatefinanceinstitute.com/resources/knowledge/finance/what-is-return-on-equity-roe/
  2. https://money.usnews.com/investing/articles/what-is-return-on-equity-the-ultimate-guide-to-roe
  3. https://capital.com/return-on-equity-roe-definition

Avoiding Investing Mistakes

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“You have to learn how to value businesses and know the ones that are within your circle of competence and the ones that are outside.” Warren Buffett

Research shows that most active investors underperform the market over the long-term, according to CNBC. In reality, profitable day traders make up a very small proportion of all traders. Only 1.6% of all day traders are profitable in an average year, according to an Haas School of Business University of California, Berkeley, study. This means that’s roughly ninety-nine out of every one-hundred day traders fail and lose money. And, “overconfidence can explain high trading levels and the resulting poor performance of individual investors,” Brad M. Barber and Terrance Odean of the University of California, Berkeley concluded.

These facts makes it clear that the odds are stacked against the ordinary retail trader or investor. Thus, you have to tread carefully if you want to achieve success over the long term.

Building an investment framework

Multitudes of successful investors, including both Berkshire-Hathaway’s billionaires Warren Buffett and Charlie Munger, believe it is essential to avoid high-risk equity investments at all costs. This means avoiding investments and businesses that have a high chance of failure. It also means avoiding any companies that are difficult to understand or fall outside of your circle of competence.

Following a few basic guidelines can help any investor avoid significant losses from struggling and failing companies.

Another piece of investing advice is not to overpay for companies. If you don’t understand the value or how to value a business, then that is a pretty clear indication that it does not fall inside your circle of confidence, and thus, it might be better to avoid the investment. Buffett believes that the market will eventually favor quality stocks that were undervalued (margin of safety) for a certain time.

Finally, investors shouldn’t rush to get rich quick and they should follow an investment plan and rules. Investors who rush to get rich tend to take unnecessary risks such as borrowing money to purchase stocks, buying stocks they don’t understand or allocating capital to opportunities that seem too good to be true. Moreover, research continues to show that investors who stick with a comprehensive long-term investing plan tend to outperform those who collect stocks and constantly jump in and out of the market. All of these actions can lead to significant losses.

The key investment principle of not being in a rush helps ensure you’re not rushing into anything you don’t understand or taking on too much risk. In short, being patient and not rushing into investments is a very low-tech and straightforward way of trying to eliminate mistakes.

By following this advice, an investor may be able to improve their process and outcome.

In the words of arguably the world’s most successful long-term investor, Buffett states, “We expect to hold these securities for a long time. In fact, when we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever.”

References:

  1. https://faculty.haas.berkeley.edu/odean/papers/Day%20Traders/Day%20Trading%20and%20Learning%20110217.pdf
  2. https://www.cnbc.com/2020/11/20/attention-robinhood-power-users-most-day-traders-lose-money.html

Stay Invested – Time in the Markets

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“Time in the markets, not timing the markets.”

A common mantra in investing circles is ‘it’s about time in the markets, not timing the markets’. In other words, the best way to make money is to stay invested for the long term, rather than worrying about short term volatility or whether now is the best time to invest.

Value investing guru Benjamin Graham once quipped that “in the short term the stock market is a voting machine” that measures the popularity of companies and the sentiment of investors, whereas in “the long term it is a weighing machine” that measures each company’s fundamentals and intrinsic value.

Time in the market works because it takes this ‘guess the market bottom’ element out of the equation. By focusing on the long term, it’s easier to ignore the volatility of markets. Sure, it’s still scary watching the value of your share portfolio fall from time to time.

Time in the market is really about harnessing the power of compound interest. Compounding is the best thing about investing. Albert Einstein once said “Compound interest is the most powerful force in the universe. Compound interest is the 8th wonder of the world. He who understands it, earns it, he who doesn’t, pays it.”

With compounding, your money accumulates a lot faster because the interest is calculated in regular intervals and you earn interest on top of interest. Compounding is usually what makes investors like billionaire investor Warren Buffett wealthy. If you are able to achieve a consistently high annual rate of return over the long term, building wealth is almost inevitable. And Buffett has never tried to time a market in his life.

But pushing and pulling your money in and out of the market stymies the compounding process. And all it takes is one massive mistime to end up back at square one given the fact that market can never be timed. Investor Peter Lynch said it best: “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in the corrections themselves.”

Compounding plays a pivotal role in growing your wealth. When using compounding, the results will be small at the start but over time, your wealth will accumulate fast. Warren Buffet is known to make the majority of his wealth later in his adult life and this is due to the compounding interest effect on his assets and invested capital.

Missing the best days

Timing the markets involves trying to second-guess the ups and downs, with the hope that you will buy when prices are low and sell when they are high. This can be lucrative if you get it right consistently, but this is very difficult to do and getting it wrong means locking in losses and missing out on gains.

Not only is timing the market difficult to get right, it also poses the risk of missing the ‘good’ days when share prices increase significantly. Historically, many of the best days for the stock markets have occurred during periods of extreme volatility.

Instead of trying to time the market, spending time in the market is more likely to give you better returns over the long term. It is best to base your investment decisions on the long-term fundamentals rather than short-term market noise and volatility.

Value of $10,000 investment in the S&P 500 in 1980

Source: Ned Davis Research, 12/31/1979-7/1/2020.

This chart uses a series of bars to show that from the end of 1979 until July 1, 2020, a $10,000 investment would have been worth $860,900 if invested the entire period. Missing just the 10 best days during that period would reduce the value by more than half, to $383,400.

Anybody who pulls money out in the early stages of a volatile period could miss these good days, as well as potentially locking in some losses. For instance, between May 2008 and February 2009 in the depths of the global financial crisis the MSCI World index dropped by -30.4%. By the end of 2009 it had bounced back +40.8%.

References:

  1. https://www.edwardjones.com/us-en/market-news-insights/guidance-perspective/benefits-investing-stock
  2. https://www.fa-mag.com/news/retirees-are-leading-precarious-financial-lives-42426.html
  3. https://www.tilney.co.uk/news/it-s-about-time-in-the-markets-not-timing-the-markets
  4. https://www.fool.com.au/2020/10/06/does-time-in-the-market-really-beat-timing-the-market/
  5. https://www.fool.com.au/definitions/compounding/

Growth vs. Value

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“Empirical evidence suggests that value stocks outperform over the long term, even if growth has out performed value in recent years.” Bankrate

Recently, growth stocks, such as Microsoft, Amazon, Tesla and Apple, have handily outperformed value names. But it’s not always that way, and many seasoned investors think value will once again have its day, though they have been waiting on that day for more than a decade.

The difference between the two approaches are:

  • “Growth investors look for $100 stocks that could be worth $200 in a few years if the company continues to grow quickly. As such, the success of their investment relies on the expansion of the company and the market continuing to value growth stocks at a premium valuation, as measured by a P/E ratio maybe, in later years if the company continues to succeed.”
  • “Value investors look for $50 stocks that are actually worth $100 today, not in a few years, if the company continues its business plan. These investors are typically buying stocks that are out of favor now and therefore have a low valuation. They’re betting on the market’s opinion changing to become more favorable, pushing up the stock price.”

“Value investing is based on the premise that paying less for a set of future cash flows is associated with a higher expected return,” says Wes Crill, senior researcher at Dimensional Fund Advisors in Austin, Texas. “That’s one of the most fundamental tenets of investing.”

Growth investing and value investing differ in other key ways, too, as detailed in the table below.

Many of America’s most famous investors are value investors, including Warren Buffett, Charlie Munger and Ben Graham. Still, plenty of very wealthy individuals own growth stocks, including Amazon’s founder Jeff Bezos and hedge fund billionaire Bill Ackman, and even Buffett has shifted his approach to become more growth “at a reasonable price” oriented as of late.

Yet, sometime in the future, and unfortunately no one can forecast when, it appears guaranteed that value will outperform growths as an investment for a long period of time.

Typical investing wisdom might say that “when the markets are greedy, growth investors win and when they are fearful, value investors win,” says Blair Silverberg, CEO of Capital, a funding company for early-stage firms based in New York City.

If you’re an individual retail investor, it is wise to stick to fundamental investing principles or otherwise consider buying a solid index fund, such as the S&P 500 that takes a lot of the risk out of investing.

References:

  1. https://www.bankrate.com/investing/growth-investing-vs-value-investing/

Small company, higher quality “value” stocks

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Small company, higher quality “value” stocks are better long-term investments than large company growth stocks.

Small cap value stocks are assets that may be temporarily undervalued by investors. These companies typically grow at a slower pace than the typical company.

Over the past decade, growth stocks have largely outperformed small cap value stocks.

Small cap value stocks are currently undervalued by the market. If investor sentiment is correct and other investors ultimately recognize the value of the company, the price of these stocks may rise over the long term.

Historically, the stocks of smaller companies have outperformed those of larger companies. And relatively inexpensive stocks have outperformed more expensive stocks.

Over a long term, small cap stocks deliver superb investment returns, better than any other asset class and many percentage points better than the equity market as a whole. And, there exist a body of research that shows that over a long investment horizon, small cap stocks have outperformed their large cap brethren. From 1928 through 2014, U.S. small-cap value stocks turned in a compound annual return of 13.6% compared with 9.8% for the Standard & Poor’s 500 Index.

Finance professor Kenneth French and Nobel laureate Eugene Fama, say that “…small company value stocks are better long-term investments than large company growth stocks, though they add (naturally) that they are also riskier.”

Currently, small company, higher quality “value” stocks are trading at their biggest discount since the dot-com bubble in 1999-2000.  But it is important for investors to invest in small cap stocks that have the “quality” factor and their corresponding discount are the reason that quality has become the significant factor in explaining the sectors out-performance. 

For quality, it is important to look for companies with above-average sustainable growth and profitability—and strong free-cash flow generation.  It is also important to focus on return on assets, rather than return on equity, since the latter can be boosted by debt. Additionally, it is important to prefer companies with conservative balance sheets.

The simplest solution for investors wanting to embrace higher quality, smaller cap value stocks, is to buy a low-cost exchange-traded fund which invest small company, higher quality “value” stocks.  BlackRock offers the iShares Core S&P Small-Cap ETF (IJR), with a low expense ratio of 0.07% and Vanguard offers Small-Cap Value ETF (VBR), with a low expense ratio of 0.07%.

One of Wall Street secret: Investors can make good money with the stocks of smaller companies whose names aren’t necessarily household words.

In the long run, small-cap value is the undisputed champion of the major asset classes such as large cap growth. But the operative phrase there is “in the long run.” Over shorter time periods, small-cap value stocks can be disappointing and significantly trail asset classes such as large cap growth.

References:

  1. https://www.marketwatch.com/story/a-strategy-to-outsmart-the-sp-500-bubble-2020-08-20?mod=mw_quote_news
  2. https://www.marketwatch.com/articles/a-tale-of-two-indexes-1516896321
  3. Fama, Eugene F. and French, Kenneth R., A Five-Factor Asset Pricing Model (September 2014). Fama-Miller Working Paper, Available at SSRN: https://ssrn.com/abstract=2287202 or http://dx.doi.org/10.2139/ssrn.2287202
  4. https://www.marketwatch.com/story/buy-the-best-performing-stock-sector-for-87-years-2015-03-11
  5. https://www.marketwatch.com/story/youre-loving-high-flying-growth-stocks-now-but-your-money-should-be-in-these-companies-this-market-pro-says-2020-08-20