Amazing value investing advantages over day trading or mutual funds

Ordinary investing activities can never compare with the amazing value investing advantages.  Many a successful value investor will vouchsafe for this.

The benefits of value investing, over day trading and investing in mutual funds, are of two categories, viz. tangible financial results and subtle indirect benefits.

Direct and tangible investment advantages:

• High degree of investment protection;
• Regular and superior dividend income;
• Good capital appreciation;
• Saving high fund management fees collected by mutual funds;
• Attaining financial freedom;
• Assured, long term wealth creation;
•  

Subtle, incidental benefits:

• Conquering the negative emotions of greed and fear;
• Developing the virtue of patience;
• Peace of mind;
• Better health;

How does value investing bestow these advantages? The answer is simple; it is based on a long and thorough research before making crucial investment decisions.  The research includes studying the companies, their balance sheets, understanding their business models, analyzing various financial ratios, assessing the integrity of the managements, etc.  It relies mainly on the intrinsic value of the underlying assets – shares, bonds and other financial instruments.  It ignores short-term fluctuations in prices.

On the other hand, conventional investment methods lay heavy emphasis on price movements.  While the day traders seek to make a profit out of price movements during the trading hours of the day, mutual fund’s performance is gauged by returns, which means the change in the net asset value (NAV) of the fund, over a certain period of time, based on market prices. 

Mutual fund managers, who are supposed to be financial experts; on whom millions of lay investors repose their trust and entrust their life’s savings, themselves are under severe pressure to improve the returns, and therefore are often forced to churn the portfolios frequently, leading to making inappropriate buy and sell decisions.  All this results in higher costs and inferior long-term wealth creation for investors.  Thus they end up doing disservice to the investors.

Day trading in stocks is pure gambling; it cannot be called investing at all.  It is fraught with grave risks.  Day traders place bets based on anticipated price movements of stock and commodities on the exchanges.  Since the expected gains are small, in order to magnify the gains, brokerages encourage them to increase the size of the bet (total value of the transaction), by demanding just a small deposit, usually 5 to 20%, called the margin. This is a double-edged sword, magnifying both the gains as well as losses by as much as five to 20 times.  Small, lay investors invariably suffer losses.

Constant monitoring of prices by day-traders and reading performance reports by mutual fund investors increase anxiety levels and leads to health problems.  However, having made investments after solid research, value investors can simply forget their investments for months and years.  They can relax in the comforting safety of their method that has stood the test of time.

In the end, wonderful value investing advantages like of safety of capital and superior returns are not offered by any other method of investing.

Yes, value investors are retrograde - for a good reason too!

Speculators are always crystal gazing the future; it seems they are always forward-looking.  On the other hand, value investors always look back into the past. As far into the past as possible. And so can we call them retrograde?  I say yes, with pride. A value investor is retrograde literally, and for a good reason too!

Every day I read in financial newspapers that the Indian share market is reasonably priced.  They say that presently the market is trading only at 15 times the two year forward earnings. They add that this is in contrast to the long-term average of 16 times, which is the norm.

Two years forward earnings?  Who can predict what profits may a company may earn two years hence? What greater foolishness could there be than buying a share at 15 times the earnings expected two years hence? while value investors are taught not to buy shares at not more than ten times the past earnings?

Further, when we say past earnings, we don't simply mean the earnings of the previous year. We mean the average earnings in the five preceding years.  We take this extra precaution to avoid buying a share by mistake.  Because a company may have a bumper year owing to sheer luck. Whereas the five-year average past earnings criterion will eliminate that risk.

When you make investment decisions based on future earnings, you are ignoring the time-tested concept of buying the share at or below its intrinsic value and paying a fair price.

While the media is howling the market is cheap, I am scouring the market every day, with utter disappointment, to make the new find of a reasonably priced share!

Conclusion

We value investors do not mind the world labelling us retrograde.  Looking back into the past is the essential ingredient of our craft. For, when investing it is far more beneficial to be retrograde than crystal-gazing the future.

Investments in Indices can be sold - no dilemma in sell decision

This article is in fact a continuation of the debate initiated in the last article, "Buying shares is easy - decision to sell is the most difficult".  I advise readers to first read the previous post and then continue here.

One can buy or invest in an index like BSE Sensex, NIFTY and NIFTY Junior, etc., through what are called exchange traded funds (ETFs).

Investment in indices are recommended for lay investors (not value investors) as it gives security through diversification.  On the contrary value investors create concentrated portfolios comprising of not more than 20 stocks, after thorough research.  But a value investor may invest in an index fund two reasons, as follows:

1. As a hedging strategy or in other words as a buffer against risk and/ or;
2. To evaluate the performance of her own portfolio against the index;

Our example portfolio 2K15 is built exactly for these reasons, besides to be used as a practical teaching tool.

In my previous post "Buying shares is easy - decision to sell is the most difficult", I had explained how complicated is the decision to sell.  But, when a value investor builds a significant portfolio of index funds, he may sell this portfolio and book profit when the market is in an unreasonably bullish or enthusiastic zone.  He can simply buy the same index when the market falls and moves into unreasonably pessimistic zone.

All the objections to sell,  raised in my earlier post do not apply in the case of a portfolio of index fund because of the following inherent reasons/ differences between value investing portfolio and an index fund:

1.  No midnight oil burning research has gone into building the portfolio - the companies get included in the index simply based on the highest market cap, which means the criteria for inclusion is market's opinion about the scrip and not based either on the companies' fundamentals or fairness of valuations;
2. Investors in index based funds do not get any meaningful returns by way of dividends. Managements of most of the constituents of the indices in India, like BSE Sensex and Nifty 50, pay negligible portion of their profits as dividend, usually 10-12%.  Considering that these scrips are priced unreasonably higher, the dividend yield (dividend per share divided by price) is abysmally low.  Under these conditions, the only way an investor can earn a return on his investment is out of price movements - that is buying when price is low and selling when price is high.  On the other hand since the scrips constituting a value investor's portfolio yield a regular and handsome dividends in addition to capital appreciation on the back of companies' growth, there is no need to sell the shares;

In conclusion, there need not be any serious dilemma in a sell decision of index funds as opposed to constituents of a value investing porfolio.

When to Sell a Stock?

Buying shares is easy – decision to sell is the most difficult. Questions, “when to sell a stock?” and “how to sell shares?” plague even seasoned value investors. Day traders, involved in online stock trading and quite often short selling stocks are of course not perturbed about selling – they buy and sell stocks and shares hundreds of times a day. So let us examine why is a decision to sell so difficult?  What are the issues involved? For who is selling difficult? In detail.

Buying shares is easy – decision to sell is the most difficult. Questions, “when to sell a stock?” and “how to sell shares?” plague even seasoned value investors. Day traders, involved in online stock trading and quite often short selling stocks are of course not perturbed about selling – they buy and sell stocks and shares hundreds of times a day. So let us examine why is a decision to sell so difficult?  What are the issues involved? For who is selling difficult? In detail.

For who is it difficult to sell?

Let us address the “for who” aspect first.  For the millions of day traders all over the world, there cannot be a more mundane or stupid question than this.  They buy and sell shares hundreds of times a day and millions of times in their lifetimes.  They are a trigger-happy lot with license to sell.  Some sell what they do not even own, which is called short selling. Please don’t think that I am preaching from a high moral ground.  I had been a part of the tribe of day traders myself, until one day I severely burnt my fingers, and until I chanced upon the book “The Intelligent Investor”, a classic work of Benjamin Graham, and gradually got converted in to a value investor.  So when I speak I am speaking out of my personal experience, from both the worlds.

People sell stocks for many reasons, including a few bizarre ones.  A Hollywood actress appears to have sited a reason that she simply hates to see red, and the moment she spots a red coloured blip on the computer screen of the online stock trading platform, on any of the stocks listed in her portfolio, she immediately sells!  

On the other hand, for a value investor, the decision to sell is the most difficult.  

Why? 

Lets examine next.

What triggers the itch to sell?

There are two types of situations - one frivolous, and the second a serious one, backed by logic.

Let us get done with the frivolous one first.

Silly Reason  

I have mentioned many times in various posts that the real enemy of an investor lies within and not without.  The monkey natured mind simply cannot keep quiet.  Once an investment in shares is made (after thorough research), the investor is expected to simply forget the investment.  Instead one actually monitors it every day.  Stock markets being highly dynamic in nature, the market value of the investments constantly changes.  If it goes down, a red blip appears on the screen, and immediately it triggers fear in the mind, on the other hand if the investment value goes up, immediately the itch to sell and book the profit begins.  

The uninterrupted chatter produced by financial news channels further compounds the dilemma of the investor.  

The answer to this frivolous itch to sell is a simple NO!

Serious Dilemma

The real and serious dilemma, whether to sell or not sell arises when the market is at the peak and the share purchased by the investor has actually steeply appreciated - say two to three times - and the investor is tormented by the fear that if one does not sell, there is a real danger of missing the opportunity to book profit and invest the handsome harvest in a safe, fixed income yielding instrument like a fixed deposit with a bank or a bond.  

This line of thinking is further strengthened by the reasoning that the same share can again be bought by the same investor in future at a lower price when the market falls to an unreasonably pessimistic level.  Indeed, this is a perfect and sound logic!

Let us now examine the real issues involved in the serous dilemma. 

Why is it such a difficult decision to sell?

Philosophical perspective:

For a value investor holding a share in a company is ownership of the company itself, however small the stake may be.  For her it is like she is one of the partners of the company.  It is her business.  It is her baby. It is like her home, meant to live for a lifetime – not for trading!   This is not just an emotional attachment, but based on sound logic and age-old wisdom too.

Thorough prior research:

A value investor would already have conducted a prolonged and thorough research of the company before making the investment. Having already passed the stringent scrutiny there should be little hesitation to hold the shares for long time, maybe even forver, unless some fundamental change has happened either within the company like ownership or management change or outside, in the business environment;

Excellent management:

Usually the promoter directors of great companies also act truly in a fiduciary capacity – that is in the interest of minority shareholders rather than in their self-interest.  In certain exceptional cases the management simply excels in growing shareholder wealth.  A rare but perfect example is Berkshire Hathaway Inc., under my guru, Warren Buffett.  In such a situation shareholders don’t sell their shares as they see no reason to do so – their wealth automatically grows – they simply have to hold on to their shares!

Shares generate lifetime cash flows:

Shares in the portfolio of a value investor generate healthy dividends year after year.  The quantum of dividend and dividend yield to the investor keeps on increasing on the back of growth in business issue of bonus shares.  These dividends earn back the capital invested in a few years and still continue to generate dividend cash flows for the investor for perpetuity.

EPS growth based price appreciation:

The price of scrip fluctuates for two reasons – short-term speculative activity and long-term growth or decline based on the earnings per share (EPS).

When the market is unusually bullish the share price may go up disproportionate to its EPS.  That is instead of trading at a normal price to earnings (PE) multiple of say 10 -15 it may be trading at say 30 or 40.  In such a situation the price might have appreciated two or three times the cost of purchase of an investor, triggering the itch to sell and make profit.

On the contrary the price of a share may go up, not because of speculative reason but on account of EPS growth, which in turn has grown on the back increase in sales and profits of the company. 

If an investor sells merely to book profit because the price has appreciated, he will miss out on the natural and real increase in price on account of growth in EPS in the long term.

The argument in favor of selling:

Since markets see steep ups and downs, investor can sell when the price has appreciated steeply and the same share can be purchased again in future, when the market falls to pessimistic levels. 

But as I have experienced it myself, once we liquidate our holdings phenomenal changes in the long-term prospects of the company or to the country’ economy or the market behaviour could take place, making the share expensive and shut us out of investing in the same company for years, effectively depriving us off of growth in dividends and bonus shares forever. Therefore Warren Buffett says that dancing in and out of investments may not be a good idea.

My Experience in Liquidating Entire Holding

As far as my actual personal experience goes, I had completely sold off my investment only once, that is, after my conversion to value investing.  This was in the years 2009-10.  After the market meltdown following the Lehman Brothers incident, the BSE Sensex lost 57% value from its high of 20325 in January 2008 to 8762 in March 2009.  Financial markets were agog with doomsday predictions.  Comparisons were made to the Great Depression of 1930s.

G20 countries and leaders, including India, took concerted actions to stimulate the global economy. 

All this certainly unnerved me.  

Of course I did not panic and sell at the bottom.  I held on to my portfolio.  

However, when the market again rebounded steeply to about 15600 by August 2009 (a 78% recovery in just five months), I had sold my entire portfolio. The market advanced rapidly for sometime and steadily over many years.  I could not invest in the share market for many years because the prices had become unrealistic and I was simply shut out of the market.

I could reenter the market only when BSE Sensex was at 20599.

Have I not missed the growth in the Sensex of about 10000 points by my sell action?

Suggested Further Reading

• How Frequent Changes to Mutual Fund Portfolio Affect Investor Interest?
• Margin Trading Definition
• What is Short-Covering?

Conclusion

We have seen that buying shares is quite easy – decision to sell is the most difficult to make. However even though questions like, “when to sell a stock?” and “how to sell shares?” plague even seasoned value investors and day traders, involved in online stock trading and quite often short selling stocks are selling away to glory, the debate proves that stocks of excellent companies should be held forever and shall not be sold.