Buy and hold. The “hardest” investing strategy ever known to man.
A strategy that surged in popularity only because two energetic and rich philosopher has proven the concept, not once, not twice, but in every market crash.
They were Warren Buffett and Charlie Munger, the dynamic duo that carried the belief of society in long-term investing strategy.
Through their investment vehicle, a conglomerate named Berkshire Hathaway, the duo compounded no less than 19.58% annual return since 1965 which they claimed to be 3,787,464% in overall gain (data: Berkshire Shareholder’s Letter 2022).
At the same time, the market (S&P 500) can only go as high as 24,708%, returning only 9.9% annually. It was crazy to the point where:
If you trust Buffett and put $1 to his company in 1964, that one dollar is now equivalent to $37,874.
38 thousand-fold!
But how do they do it?
Through consistency and continuous learning over the long time horizon.
Munger once said:
“Over the long term, it is hard for a stock to earn a much better return than the business, which underlies it earnings. If the business earns 6% on capital over 40 years and you hold it for 40 years, you are not going to make much different than a 6 percent return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you end up with one hell of a result.”
This quote alone underlines the evolution of Warren Buffet that people less likely talk about. Without Munger, Buffett might still be looking for “Value Stock” that are selling under it’s book value.
Although Buffett’s investing approach has evolved from finding supercheap stock to finding great quality business? they said they haven’t leaving Value Investing philosophy. They believe that:
“All intelligent investing is value investing.”
You buy businesses that are selling under its potential value, that’s value investing.
You can’t buy a company no matter what the price tag is and expecting you’ll eventually get fair return. Even if the company is that good, most of the time the price tag aren’t justified.
The only way to justify the price tag for any given stock in stock market, is through extensive analysis to the individual company. You can use the framework provided by Chuck Akre here.
- Extraordinary business.
- Talented management.
- Great reinvestment opportunity (and histories).
Every good business, can only extract its value when they’re managed by competent manager, and can retain its business long enough by reinvest the profits.
After all, any business is built to create value, to customer and the investor.
The Misunderstood Value Investing
Value investing is often misinterpreted as merely seeking stocks with low PE (Price to Earnings) and PBV (Price to Book Value) ratios.
“My sense is that there has been a simplistic association between value investing and the basic idea of buying statistically cheap stocks.”
Michael Mauboussin
While many famous value investors, including Ben Graham — regarded as the father of Value Investing, favored cheap stocks, the idea that value investing is all about buying stocks with low PBV or PE ratios was propelled by the Fama-French paper, published in 1992, on factors that are associated with excess returns.
It’s worth noting that GEICO, then a growth company, played a large role in the success of both Graham and his most famous student, Warren Buffett (Chairman and CEO at Berkshire Hathaway)
At its core, value investing is buying something for less than its worth.
Main Idea 1: Undervalue Stock Criteria
Investors mistakenly equate value investing with low PE and PBV ratios. While these metrics are crucial, it’s not the whole story. Low PE and PBV ratios are signals of potentially undervalued stocks, but they don’t guarantee success. To effectively apply value investing, one must consider other factors, such as the company’s competitive position, growth potential, and industry dynamics.
Actionable Tip: Alongside low PE and PBV, analyze a company’s financial health, management quality, and future growth prospects before making an investment decision.
Example: Consider a company with a low PE and PBV, but its industry is in decline, and its management has a history of poor decision-making. This may not be a good value investment despite seemingly attractive ratios.
Main Idea 2: Diversification and the Quest for Gems
One common misunderstanding is that value investors should buy a large number of stocks and hope to stumble upon a few gems. While diversification is a sound strategy, a haphazard approach to buying numerous companies may dilute the potential returns. The “buy and pray” mindset doesn’t align with the core principles of value investing.
Actionable Tip: Diversify your portfolio thoughtfully by selecting a mix of stocks that meet your value investing criteria, rather than simply accumulating a large number of companies. Focus on the quality of your investments, not just quantity.
Example: An investor buys 30 stocks without thorough analysis, hoping a few will outperform. Instead, select a smaller, well-researched portfolio of 10 companies that meet the criteria for value investing.
Main Idea 3: Understanding the Margin of Safety
Value investors are often advised to sell when a stock’s PE and PBV ratios touch their margin of safety. However, this can be a misleading guideline. A low PE and PBV ratio doesn’t automatically indicate a value investment, and these ratios should not be the sole determinant of when to sell.
Actionable Tip: Regularly reevaluate your investments by looking beyond PE and PBV ratios. Consider other factors such as changes in the company’s fundamentals, the competitive landscape, and the overall economic environment.
Example: An investor decides to sell a stock solely based on its PE and PBV ratios hitting the margin of safety. However, the company’s fundamentals remain strong, and it later surges in value.
In Conclusion:
Value investing goes beyond the surface-level analysis of low PE and PBV ratios. Investors should seek undervalued stocks while considering various factors. Diversification is important but should not lead to a “buy and pray” strategy. Lastly, determining when to sell should be based on a comprehensive assessment of the company’s overall health and the investing landscape.
Final Takeaway:
Value investing, when properly understood and applied, can be a robust strategy for long-term wealth creation. Take the time to conduct thorough research, and don’t rely solely on PE and PBV ratios. Strive for a balanced portfolio, and remember that the margin of safety is not solely about ratios but also about the underlying fundamentals of the companies in your portfolio.
So, are you ready to kickstart your investing journey right now? Or you’ll just shut down your investment account and keep YOLO-ing?