Done well, value investing is a successful, proven, and safe way to invest.
The logic of the approach - buying an asset for less than its underlying value - is irrefutable, and the records of those that practice it are convincing.
However, an understanding of the principles of value investing isn't enough. In investing, mistakes are inevitable, and the key is to learn from them, and avoid repeating them. Here are six of the best.
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1. Focusing only on the numbers
One of the most common investing mistakes, especially for the inexperienced, is to concentrate only on a stock's financial data.
Applying a price-to-earnings ratio, a book value multiple, or a discounted cash flow analysis can provide very precise estimates of value. But that's not all there is to analysing stocks.
The big four banks, for example, all carry forecast dividend yields of about 6% to 7%, and price-to-earnings ratios of around 10 to 12. Looking at the numbers, they're closely matched.
When you consider the risks entailed by ANZ's Asian expansion and National Australia Bank's (NAB) aggressive push for market share however, suddenly the numbers don't seem to tell the whole story.
These qualitative factors are the reason we favour Commonwealth Bank and Westpac over ANZ and NAB. Before looking at the numbers, make sure you truly understand the business that's generating them.
2. Mistaking permanent declines for temporary ones
In the hunt for value, it's often necessary to buy stocks with a few fleas. When businesses hit rough patches and earnings temporarily decline, it can be a great time to buy.
This strategy led to successful 'Buy' recommendations on Cochlear at $19.04 on 18 March 2004, and Leighton Holdings at $7.83 on 11 May of the same year.
We have a positive recommendation on Aristocrat Leisure today for the same reason.
While mismanagement, a poor product line-up, the strong Aussie dollar, and cyclical headwinds are all hurting Aristocrat in the short term, we expect this business to perform well in the long run.
The risk is if its current problems aren't temporary. If Aristocrat's profits stay permanently depressed, we'll have overpaid for this business, and be guilty of having mistaken Aristocrat's structural decline for a cyclical one.
3. Buying low-quality businesses
Owning high-quality businesses over the long run is the key to successful investing.
Unfortunately, high-quality businesses are seldom cheap. Value investors therefore often end up with portfolios full of cheap but low-quality stocks, entailing greater risk, more stress, and higher stock turnover.
It's better to fill your portfolio with high-quality businesses, especially if you're patient and buy opportunistically.
4. Neglecting economic considerations
“If you spend more than 13 minutes analysing economic and market forecasts, you've wasted 10 minutes.”
Ever since uttering that sentence, legendary fund manager Peter Lynch gave value investors a free pass to ignore the economy. Or so they thought.
Lynch's advice does not mean that you can completely ignore the economy. It means that the success of your investments should never rely on specific, short-term economic forecasts.
An investment in Rio Tinto, for example, hinges largely on the continued strength of China's economy and its building and infrastructure boom. That's an economic forecast we're not willing to gamble on at current prices.
An appreciation of cycles, rather than economic predictions, should underpin your stock purchases and disposals.
5. Ignoring the market
As a value investor, a healthy scepticism of the market's wisdom is a necessity: whenever you buy something, it should be because you think the market is pricing it incorrectly.
When you're right, the rewards of ignoring the market can be enormous. The market wrote RHG Group down from $0.95 to $0.05 before our positive recommendations were vindicated.
But when you're wrong, it can be a disaster. Backing ourselves over the market explains why we were far too late in pulling the pin on Timbercorp, for example.
Share price movements should never influence your analytical process. But it is necessary to be aware of them; they can offer a timely prompt to reconsider your thinking. When you're going against the grain, make sure you know why you disagree with the market and have good reason for doing so.
6. Mistaking price and value
If you're aiming to buy stocks for less than their intrinsic value, a lower price can only mean better value, right? Wrong.
Consider Telstra, which is trading close to its lowest ever price. By that simple logic, it should be more attractive than ever. But the decline of its traditional fixed-line business means it's just not worth the high of $9.20 it hit more than a decade ago, nor the $4.80 or so it traded at in 2008.
It's tempting to anchor to previous prices but they offer no clue regarding today's value. The fact that a stock has fallen does not in itself make it cheap; only the difference between its intrinsic value and the price at which it trades does.
Avoiding these classic value investing mistakes will do wonders for your returns. Use this six-point checklist to sift out these mistakes in your own portfolio.
JUNE 29 — We maintain our BUY rating on Hong Leong Bank Bhd (HLBB), with an upgraded fair value of RM15.30/share (previously RM14.70/share). This is based on an adjusted (for rights) ROE of 16.2 per cent for FY12F, leading to a fair P/BV of 2.4x. HLBB has now provided further details of the revenue synergies arising from the merger with EON Cap.
