The New Value Investing

How to Apply Behavioral Finance to Stock Valuation Techniques and Build a Winning Portfolio

C. Thomas Howard

• Publisher: Harriman House
• Year: 2015
• ISBN:
  9780857193971
• Edition: 1
• Topic: Business
• Subtopic: Stocks
• Index: Business

The aim of value investing is to identify stocks that are undervalued and which can be expected to produce an above average return in the future. And the message from the history of investing is clear: if you successfully pursue a value investing strategy over the long term, you will earn an above average return on your portfolio. The goal of The New Value Investing is to help you identify undervalued stocks and teach you how to build your own successful value investing portfolio.Added to this, it is important to understand that value investing is inextricably linked with behavioral finance, and research advances in this area in recent years strengthen the case for value investing. The author explains how stock prices are determined by emotional crowds, how this leads to mispriced stocks and opportunities for the value investor, and how you can harness the insights of behavioral finance to improve your value investing approach.As you work through this book, the author shows how to follow the path from analysis of the economy, to the industry, to company financial statements, to creating a value range for a company's stock. You will learn:- How to remove emotion from your investment process.- The essential elements of portfolio construction.- What a value investor should observe in the wider economy and the market.- Where to find investment ideas.- How to read a company's financial statements from a value investing perspective.- Dividend valuation, earnings valuation and other valuation techniques.- How to undertake a full valuation analysis, with two complete worked examples of stock valuation for real-life companies.- What professional value investors at investment funds analyse and how they make their decisions.Value investing is within everyone's reach, so why doesn't everyone use it? The key is patience. The approach works over the long term if you stick with it and the result could be extra hundreds, thousands or millions in your portfolio at the end of your investment horizon.

Chapter 1 –
Mastering Your Emotions

Summary

Successful equity investing is a combination of mastering your emotions along with building and consistently pursuing an objective investment strategy. In the chapters ahead I will be focusing on the latter of these by exploring various analytic techniques that can be used to identify attractive stocks in which to invest.

Before we dive into these details, we’ll take a look at a few basic concepts which may help you master your emotions. This is important as even a carefully constructed strategy will not allow you to outperform unless you ruthlessly drive emotions out of your decision process. In fact, value investing strategy is straightforward, but the difficult part is mastering these messy emotions.

I will weave the concepts from Chapter 1 throughout the book as they are a critical aspect of successful value investing.

The Impact of Emotion When Investing

Emotions impact the investment process in two very different ways.

First, investors make emotional decisions that can dramatically impair investment performance. For example, they tend to focus on short-term volatility and, in trying to reduce this emotional aspect, they invest in low return securities. As another example, investors limit themselves to those stocks which are familiar and, in turn, use emotional buying and, in particular, emotional selling rules. The result is inferior performance over long time periods.

Second, since the stock market is dominated by emotional crowds, prices rarely reflect underlying fundamentals. Your goal is to build a value investing strategy that allows you to harness the resulting emotionally-driven price distortions.

To further elaborate on this concept, you are not trying to outsmart other investors nor are you trying to out-analyze them, but instead you are trying to identify behavioral price distortions that can be harnessed.

As a result, you are frequently taking positions that are different and, at times, opposite the emotional crowds which created the price distortions in the first place. This means that you will receive very little social validation as you manage a portfolio or when you discuss investment decisions with others. For my part, I feel a certain sense of satisfaction when my fellow investors respond to my comments about my portfolio with a look of disbelief.

So, successful value investing involves dealing with emotions in two ways. First, you need to be in control of your emotions during the investment process. Second, you need to employ a strategy that objectively identifies price distortions which can be harnessed for the generation of superior returns.

Basic Concepts in Emotional Control

The goal of stock investing is to create as much wealth as possible and, by the way, it is OK to be wealthy. I find it surprising that I have to say something like this, but I encounter many who find it hard to say they want to be wealthy and grow their wealth. This emotion can have a profound negative impact on long horizon wealth, so give yourself permission to be wealthy.

Don’t use phrases such as “I think”, “I feel”, or “my intuition tells me” when making investment decisions. Build an objective process, involving as little subjectivity as possible. Base decisions on a careful, thoughtful analysis. This is the surest way to drive out emotions.

This does not mean emotions have to be eliminated altogether, for they are central to human nature and thus play an important role in making day-to-day decisions. But in stock picking it is critical to master your emotions when making decisions.

I make these suggestions because I believe it is the surest route to superior returns. A large body of behavioral research shows that individuals make decisions based on emotions and anecdotal information. While you may use an emotional, anecdotal approach when making day-to-day decisions, applying this same approach to investing leads to underperformance.

In picking stocks you’re not assembling a group of friends or family, but instead identifying the best possible combination of stocks for generating the highest possible return. Do not fall in love with your stocks and, when they cease to meet your criteria, sell them without regret.

When making investment decisions be sure to stay in the now. Don’t dwell on past decisions. Make the best decision you can based on the information available at the time. Some selections will generate superior returns and some will not. Accept the fact that at the time the investment decision is made, it is not possible to know if a stock will be a winner or a loser.

The best you can do is tilt the odds in your favor. Aim for 60% or more winners, which means investing in losers comes with the territory. Consequently, investment decisions that do not work out are not mistakes, but instead are an expected part of the investment process. Do not waste time and energy on regret or second-guessing past decisions. Relentlessly stay in the now.

There is substantial risk when investing in stocks but a careful examination reveals that what many think of as risk is really an emotional reaction to volatility. We know from behavioral research that we are hardwired to feel twice as bad about a loss as we feel good about an equivalent gain. We also have a hard time focusing on the long term and instead evaluate performance over short time periods. This leads to myopic loss aversion and a subsequent reduction in long horizon wealth.

As it happens, volatility has very little impact on long horizon wealth. So one of the results of driving emotions out of the investment process is to largely ignore emotionally-charged volatility. Volatility and risk are not synonymous and so when talking about risk in stocks you should not be talking about volatility. Instead, you should focus on the business and economic sources of risk and should largely ignore short-term volatility in such discussions. Ruthlessly driving emotions out of the investment process means short-term volatility plays virtually no role when making stock picking decisions.

Some of you might be thinking that investing should be about more than just earning the highest return. Shouldn’t money be put to work to encourage companies to pursue socially desirable goals? I have a different take on this. I want to generate as much wealth as possible with my stock portfolio and then use that money to support my favorite causes. In short, first be wealthy and then do good. Don’t mix good intentions with investing decisions.

* * *

When you apply these concepts to your investment decisions then you will be heading in the right direction towards mastering your emotions.

Chapter 2 –
Managing Your Stock Portfolio

Summary

Important decisions must be made at the portfolio level. A portfolio should not be the result of random stock purchasing decisions, but should be the child of a well-conceived master plan. The evidence supports the contention that trying to offset mistakes made at the portfolio level by means of skilled stock selection is all but impossible.

A key aspect of portfolio structure is the level of diversification. As the old saying goes, you don’t want to put all your eggs in one basket. This is truly the case for a stock portfolio where you want a good representation of stocks, sectors and countries. You will have to be careful to achieve the appropriate level of diversification since it is natural for an investor to focus on those things they know the best and thus produce a highly concentrated portfolio. My own experience in looking at individual portfolios confirms this: many are invested heavily in one or two stocks! Due to tax laws and personal preferences, such portfolios are hard to restructure in order to achieve the appropriate level of diversification. It is much easier to start out with proper diversification as a goal.

Another key decision is how actively you will manage the portfolio. Too active and you will find yourself responding to market noise and generating excess profits for your broker. Too inactive and you will miss the signals which allow you to pick superior stocks. In either case it is better to buy an index mutual fund and forget about managing your own portfolio. The proper level of activity will allow you to reap the benefits of value investing without making your broker rich.

Measuring performance over time is an important part of portfolio management. How well have you performed? Have you been able to beat the ma...