By Paul Nojin
In my last post I provided both anecdotal and empirical evidence that shows value investing is a dangerous and unsuitable strategy for self-managed super funds.
This is due to the high likelihood you will underperform.
Today I’m going to explain why the track record of value investors is poor, because after all, intuitively, value investing makes sense.
Of course it makes sense to buy quality companies when the share price is low relative to the economic value, and of course we all hope that whenever we buy shares in a new company it proves to have been at a price representing good value.
The problem is that the evidence shows that achieving the optimum outcomes with value investing is only possible for market geniuses like Warren Buffett. The large majority fail.
I could simply say that the reason value investing is flawed is that it typically involves betting against trends, which is usually a bad idea, but the real answer goes deeper than that.
While you might at first think that value investors have a scientific approach, because they use a formula to determine the economic value, when we drill deeper we find that in fact the approach requires you to make forecasts, which undermines the entire process.
If your long term success in the market depends on your ability to make accurate forecasts, or the ability of a so called guru to make accurate forecasts, you have a problem.
Let me explain further.
To get to the heart of the matter we need to consider the intrinsic value formula.
That is the formula that value investors use to determine the economic value of a company. It’s a long and complex formula but there are short hand versions that anyone can use.
Simply search intrinsic value calculator and you will find an endless number.
But this is a waste of time.
While at first glance it might seem like a scientific and therefore sensible way to go about investing, the truth is quite different.
While most of the inputs to the formula are black and white, there are critical inputs required that are NOT black and white.
In fact, you need to make major forecasts and assumptions to get it right using this formula and approach.
For example, you need to enter a “required rate of return”.
The higher the required rate of return the lower the intrinsic value will be, and vice versa. Get that one input wrong and your valuation will be well wide of the mark.
The formula also requires that you make assumptions and forecasts for returns on equity and payout ratios.
Those assumptions and forecasts make the intrinsic value an estimate only, and not a good one it seems given the very poor long term results of those using the formula.
The bottom line is that value investing is suitable if you are a market genius and investing billions of dollars, but for the rest of us it is a dangerous and irresponsible approach to investing in the share market.
While there is a formula involved in the process it still requires forecasts and assumptions, and that is the undoing of value investors. That explains the high failure rate. Too often they see value where it doesn’t exist, and rarely are they on board the stocks that achieve the biggest multi-year gains.
No matter how clever you are, as we discussed in the last email, your chances of succeeding as a value investor are much lower than you might think.
You will recall that 84% of US fund managers who pick stocks, most of whom identify as value investors, and most of whom justify their seat at the table with their forecasts, underperformed the benchmark index in the 5 years to the end of 2016.
This reality explains why Warren Buffett keeps mentioning his $1 wager that index investors will outperform stock picking fund managers in the long run, most of whom claim to invest like Warren Buffett himself.
Warren Buffett completely agrees with everything I’m saying in this email, assuming the audience is self-managed super funds and people investing their life savings.
If the experts can’t get it right with value investing it is madness for a self-managed super fund to try.
Especially as there are 2 alternatives that offer a far superior track record, and are much easier to implement.
Value investing is fine for Warren Buffett and for those managing billions of dollars, but it’s a dangerous proposition for SMSF, because of the very high likelihood that your long term results will be poor.
Value investing is a challenging way to invest. It is that simple.
In contrast there are ways that require much less decision making, and that have much better track records.
I will discuss these strategies in coming posts.
Next I’m going to discuss growth investing.
I received an email yesterday from a long term Member telling me he bought JIN, REA and Webjet just over a decade ago based on my recommendations. His returns are massive.
I have other clients who still hold REA from my first recommendation at $1. My first recommendation to buy Webjet was at 15 cents.
That all said, I’m NOT going to sing the praises of investing in growth stocks.
It is fine to have a minor interest in growth stocks but they should be a minor proportion of your overall investments. I will explain why in the next email.
In the meantime, to get your investing on the right track I encourage you to join The Super Investor today to take advantage of our superior approach.
Are you registered for our free reports?