This is how you can invest for value (without losing money)

Investing for value

Plenty of people like to think of themselves as ‘value investors’, but when push comes to shove they’re often circling the same few stocks as everyone else, partly due to their home bias.

Value investing is about buying a dollar for fifty cents (or as cheap a price as possible).

Today, a short look at how that can still be possible in today’s investment world.

Don’t lose money

Rule #1 of investing is ‘don’t lose money’.

Why?

Well, we know that a 25% gain is wiped out by a 20% loss.

And if you lose 50% of your capital then you need to make 100% just to get back to where you were.

Long-term buy and hold investors must steel themselves for the possibility of markets falling by 30-60% (which can occur surprisingly often), or even as much as 90% (yes, history shows that this can happen, even in the US).

There’s another aspect to this, and that’s if you look towards buying markets showing value – often those that have already experienced significant drawdowns – you can potentially generate significantly stronger returns on the rebound, often with lower risk.

Investing through a value lens can help in this regard, by directing you towards cheap markets, and away from expensive markets.

When markets go on sale

Investing is perhaps the only place where when things go on sale people run out of the store.

Why do people suddenly become paralysed with fear when markets get cheaper?

In nearly all other fields of life, when things become cheaper people buy more!

Yet paradoxically people seem to like stock prices to be high, but they panic and run away when prices crash.

Evidence?

Sentiment towards stocks was at its most bullish on 6 January 2000 (as the peak of the unprecedented tech bubble was imminent), and at its most bearish on 5 March 2009 (literally the market bottom, after the biggest financial event since the Great Depression).

You almost couldn’t make it up, but that’s precisely what the AAII Sentiment Surveys showed!

Amazing.

This is exactly why investors should focus on statistics, not stories!

Measures of value

Of course, there’s no single method for reliably measuring value in a stock market.

But if you run a series of metrics (market cap to GDP, price to book, price to sales, etc.) then most of them should align when a market is overvalued.

And, for the US at the time of writing, that’s just what they do.

Source: Hussman

This chart alone suggests that holding some cash is likely to be prudent.

Yet even extremely high valuations don’t necessarily ensure large losses.

Momentum and speculative sentiment matter in the short term.

However, if you look over 10-year and 20-year time horizons, then value measures such as the CAPE ratio – although marginally impacted by changes in accounting standards, such as to the amortization of goodwill – have had a strong predictive power for expected future returns.

Significant outperformance is frequently delivered relatively quickly from market buy signals, within 12-24 months, before the gravity of mean reversion takes hold.

Sometimes the strong returns can take a few years to materialise.

Can you time the market?

It’s true that you can’t time stock markets reliably to the week or month.

But you can clearly see when markets are offering value and when they aren’t (it may also be possible to use trends to time your entry, if you’re so inclined).

Sometimes stock markets can fall for long periods, while even a cheap market can become cheaper.

Brazil’s economic crisis has been one of the more extreme examples over the past decade, with the stock market index falling sinking lower for five long years between 2011 and 2015, before finally delivering enormous returns (the index value has since ripped more than 150% higher, from 43,000 to 115,000 points).

Capturing the upside

Few people have the desire to invest through a multi-year bear market, so how can such a risk be managed?

The first and most important point is to wait patiently until markets are cheap, so you can step over one-foot hurdles (e.g. in Brazil’s case the CAPE ratio at just 7 became a screaming buy signal in the midst of the crisis in 2015).

Note that when markets become this cheap (in Russia’s currency crisis its CAPE ratio fell to under 5) then it’s never a comfortable time to invest – that’s why everyone else is panic-selling.

A second element of the value strategy is to stage your entry into the investment, so you can average down if you need to.

In other words, if a cheap market gets even cheaper, you can happily buy more stocks.

And thirdly, remember the risk hierarchy: averaging down is psychologically much easier to do into a market index than into an individual stock, due to the company-specific risk.

A struggling company can fail, but a country index is unlikely to (if you’re going to average down into an individual stock, it should probably be a large, safe, well-established and systemic company, with consistently solid earnings and low debt etc.).

Being contrarian

Investing in cheap markets tends to pay very handsome rewards, and with reduced drawdown risk.

Most fund managers can’t do this – they’re understandably too fearful of going against the grain, or straying too far from their benchmark and getting fired.

But as an individual investor, you can invest however and in whatever you like.

Forget the US in 2020, the bargains will be elsewhere.

To find out more about our coaching programs, see here.

Published by petewargent

CEO Next Level Wealth, & AllenWargent Property Buyers, with offices in Sydney, Brisbane, & London. Leading Australian market analyst, & 6-time published finance author. For more see: petewargent.com petewargent.blogspot.com Qualifications including: B.A. (Hons.) Industrial History, Chartered Accountant (FCA), Diploma Financial Services (Financial Planning), Chartered Secretary, Advanced Diploma Applied Corporate Governance.

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