Chapter 2: Market Strategies
Old but gold
Value investing is one of the oldest investment strategies, dating back to Warren Buffett's era in the 1950s. Although it has undergone some changes over the years to stay competitive, it remains an effective approach.
What is value investing
Value investing can be interpreted in two ways. Firstly, it involves investing in undervalued stocks that are expected to reach their true valuation over time. In this sense, all types of investing can be seen as value investing, as the goal is to buy low and sell high.
However, value investing more commonly refers to using quantifiable ratios to find value, such as the price-to-earnings (P/E) ratio, price-to-book (P/B) ratio, and others. This approach emphasizes careful selection to avoid buying "overvalued stocks" and aims to identify investments that offer strong potential for long-term growth based on their intrinsic value.
How does it work
If you're practicing value investing, your initial step would likely involve using a stock screener. This tool allows you to input various ratios and metrics used to assess a stock's value. Typically, you'd be looking for stocks with reasonable or very low numbers in these metrics. For instance, value investors often prefer stocks with a P/E ratio below 25.
Once you've identified suitable stocks, the strategy would involve investing an equal amount into each of them. This approach continues with each paycheck. At the end of a period, such as a year, you would rebalance your portfolio. This entails selling off stocks that have performed well (winners) and purchasing those that have underperformed (losers). This action aims to adjust your portfolio's composition, potentially reducing your average cost while enhancing future potential gains.
Does it work
Now onto the big question: does value investing actually work? The core principle of buying "undervalued stocks" is sound and has proven effective over time. However, the specific rules some investors follow can be more contentious. For value investing to work well, it's important to modify the details while maintaining the core principle.
For example, the average P/E ratio has increased over the years, so the traditional rule of looking for a P/E below 25 should be adjusted accordingly to reflect current market conditions. This flexibility allows the strategy to remain relevant and effective.
As long as these adjustments are made, the value investing strategy is proven to work well, especially during periods with abnormal amounts of recessions or market downturns. These situations allow value investors to lower their average costs by purchasing undervalued stocks.
The companies they invest in are often less risky and tend to recover more reliably from recessions, providing stability and potential for long-term gains.