How To Improve Your Value Investing Returns

Do you really have the courage of your own convictions?

If you're a value investor, how concentrated is your portfolio? And how concentrated do you think it should be?

This is a tough call. The more concentrated, the riskier, but the better your potential returns, of course.

It all depends how and where you're finding that value and how conspicuous it is. If you found during last year's slump, for example, that you lost a huge percentage of your wealth on paper, then you may be too concentrated. The receding tide took almost all boats with it. Then again, if you had the courage of your value convictions and had done all the research you possibly could, perhaps this was an averaging down opportunity?

As Warren Buffett has said: "Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market." And as his partner Charlie Munger says, proper allocation of capital is an investor's number one job.

Decide what is right for you

So it's important to get share allocation right in the first place -- and at a level that is right for you.

I've looked before at whether there's a correct number of stocks to own, which also spawned a useful debate; each to his own here. No-one else can really make this decision for you. But if you're too diversified, you're unlikely to beat the market.

Warren Buffett's value investing mentor, Ben Graham, wrote of a portfolio strategy with a mixture of shares and bonds with a maximum of 75% shares and 25% bonds when share prices are low and demonstrating good value -- and vice-versa (25% shares, 75% bonds) when share prices are high.

Often, investors not sufficiently diversified and overly confident in the good times suffer scary losses in the bad and are unable to take advantage of buying opportunities due to insufficient funds.

The problem is made worse by the inherent psychological tendency many investors are shown to have of being too quick to take small profits and to run with the herd. Whereas, with true value stocks (profitable companies with solid assets and cash, priced well below price to tangible book value) you certainly don't want to be a forced seller. Instead, the opposite is true; you want to be able to take advantage of generalised market sentiment taking the price illogically lower.

Of course, it may well be that there has been news that shifts a company's intrinsic value, which then needs to be reassessed. If the margin of safety is no longer sufficient, then it may have to be sold at a loss; not all value shares come good, and this is a vital consideration.

Improving your value returns

I was interested to read a paper on value investing by Schroder from last November (a PDF). It makes for fascinating reading and demonstrates what value investors already know to be true.

Here are a few brief insights:

• What you pay, not the growth you get, is the biggest driver of whether you make money.
• Focus on exploiting what we CAN know (valuation) and not what we CAN'T (the macro).
• Focus on areas that offer compelling value -- the greatest driver of long-term returns.
• Being different is usually uncomfortable but often profitable.
• Understanding balance sheet risk and income growth is as important as a high yield.

Interestingly, as an aside, the paper also looks at contrarian sectors offering best value from last September, with Homebuilders, Insurance and Banks seeming to offer the best opportunities.

Andrew Tobias advised (as paraphrased by Peter Lynch): "Don't put all your eggs in one basket. It may have a hole in it." Instead, Lynch urges private investors not to rely on a fixed number of stocks, but to investigate how good they are on a case-by-case basis. He goes on to advise us: "In small portfolios, I'd be comfortable owning between three and ten stocks." Of course, he was more interested in earnings growth than out and out value.

The bottom line for me is that a value portfolio should be concentrated into a few well-researched shares, but not at the cost of too much risk, as I like to sleep at night.

http://www.fool.co.uk/news/investing/2012/04/04/how-to-improve-your-value-investing-returns.aspx?source=ufwflwlnk0000001