7 tips for valuation-driven investing

How to overcome investor biases, impulses and overconfidence, and make wise investment choices

Morningstar, Inc. 26 October, 2018 | 5:00PM
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Valuation-driven investing is about doing your homework, avoiding impulse decisions and knowing that the long game pays off.

At its core, it's a straightforward process: find the fair value of an investment, buy it if the price is sufficiently below that fair value. Then sell it when the price is significantly above the fair value of the investment.

As Warren Buffett, valuation-driven investor and founder of Berkshire Hathaway, once put it: "Investing is simple, but not easy."

Our ability to make wise investment choices is often clouded by several competing forces: investor biases, overconfidence, and the tendency to "find" evidence that confirms our views and put undue focus on recent performance. It is these challenges, as well as our mind’s ability to steer us off course, that valuation-driven investors seek to overcome. 

What valuation-driven investing can do

A valuation-driven approach cannot help investors or portfolio managers predict short-term returns or avoid short-term losses. It is intended to deliver superior long-term returns. It can help investors of all kinds define the different possibilities open to them, determine realistic estimates of future returns and losses, and identify which assets are most attractive at their current prices. Valuation-driven investing may be challenging, but we believe it is ultimately rewarding for investors because it provides a reliable path to help meet long-term investment goals.

Seven tips for valuation-driven investing

For valuation-driven investors to succeed, they must do so unconventionally. They must overcome their biases and often take actions that directly contradict the views of their peers. We have identified seven tips to help keep valuation-driven investors focused on meeting their long-term goals, even when market changes threaten to distract them.

Find the right opportunities:This requires a consistent valuation framework for estimating the fair value of an asset. It also requires a willingness to consider out-of-favor assets. The greatest value opportunities often lie in unglamorous industries or in companies that have recently experienced bad news, yet remain fundamentally strong.

Do the fundamental research: You need to be able to distinguish the low-priced assets that will likely recover (the bargains) from those that will likely not (the value traps). You will need to analyze the investment's financial statements and pay close attention to its qualitative characteristics, such as its underlying business model and governance, to determine whether these characteristics indicate a sound investment.

Stay mentally tough: Cheap assets tend to be unpopular. Valuation-driven investors must avoid being swayed by other investors' sentiments or market trends. That's why it's critical to build a solid investment process that includes a rigorous valuation framework and an insistence on a substantial margin of safety. This will help give you the confidence to stick with your decisions, as well as the willingness to change them when circumstances change and an asset no longer appears attractive.

Play the long game: Buying an undervalued asset is only the beginning. It may take a considerable amount of time for an underpriced asset to return to its fair value. Investors must be willing to hold investments for many years. Don't waste time thinking about unrealised profits and losses along the way. The market only really matters at two points: when you enter and when you exit.

Wait for the right moment: Markets do not always offer the same number or quality of opportunities. There are periods in the market cycle when prices are low and opportunities are plentiful and other periods when prices are high and opportunities are scarce. If investors cannot find assets that offer good value, they should conserve cash and wait for more attractive opportunities, rather than commit capital to lesser opportunities with limited prospects.

Avoid trading too much: Many investors believe that activity is good and low turnover in a portfolio is a sign that the manager is not making decisions. In reality, exceptional opportunities can be rare, while active trading boosts costs that act as a big drag on returns. Successful valuation-driven investors devote as much time as possible to research and as little as possible to buying and selling.

Hold a range of return drivers: A portfolio that depends too heavily on a single factor to drive returns effectively becomes a forecast of that factor. For example, returns for a portfolio concentrated in oil stocks will be too dependent on oil prices. Such factors are often very difficult or impossible to forecast accurately. Investors should therefore aim to diversify their portfolio among different securities in such a way that returns will be driven by a range of unrelated factors.

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