Why Morningstar favours valuation-driven investing

Focusing on valuations, rather than price movements, offers discipline and a margin of safety.

Michael Keaveney 15 May, 2018 | 5:00PM

 

 

Michael Keaveney: Morningstar favours a valuation-driven approach to investing, as seen in our equity research, manager selection and investment management work around the world. The approach boils down to determining what an investment is worth and getting it at a discounted price.

Let's paint a very simple picture of the worth of an investment and compare it to the ups and downs of market price. We can see both the advantages and challenges for a valuation-driven investor. The major advantage is that this approach has the potential for delivering excess returns and can also reduce risk.

Valuation-driven investors describe their entry points as having a "margin of safety" or a discount to intrinsic value; this can reduce the downside of making the investment. Another advantage is that it provides discipline, allowing investors to reduce the emotional roller-coaster effects of the markets. Investors can make poor decisions when short-term sentiment is their main guide.

One challenge is really the flipside of that discipline. Valuation-driven investors are contrarian, often buying when sentiment is poor, and selling when sentiment is too positive. It can be tough to maintain a contrarian discipline: People don't like to differ too much from the crowd, but it is needed with this approach.

Another related challenge is that valuation-driven investors must take a long-term view, which isn't easy in our modern world. Finally, the work of establishing true worth is easier said than done. Deep fundamental analysis on the key drivers of returns, is an ongoing requirement.

We believe that valuation driven investing can work for individual securities and asset classes to deliver better risk adjusted returns to investors. In the words of famed investor Warren Buffett, "Price is what you pay. Value is what you get."

For Morningstar Investment Management, I'm Michael Keaveney

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Michael Keaveney

Michael Keaveney  Michael Keaveney, CFA, is Director, Investment Management at Morningstar Associates, Inc.