Starting a deli on the street corner is investing. Buying a house is investing. Studying at a college is investing. Depositing money in the bank is investing. Holding stocks is investing. We have always been looking for ways to invest our time in the most productive manner. We also aim to invest our savings to cope with inflation and grow our wealth. But what is the best way to invest? To answer this question, we have to limit the definition of investing to commitment of money or capital in order to gain a financial return in the capital market. This is because we are not interested in discussing issues such as the cost and return associated with higher education or watching television all day long. Instead, we are concerned with the realization of monetary return provided by commitment of capital in purchasing, holding, or selling securities in the capital market.
Investing in the capital market involves two major methodologies: momentum investing and value investing. The financial sector has evolved over the past fifty years to include technological advances that made the following possible: algorithmic trading, online exchange, and distal transaction. These technological advances also help analyze data and graphs in seconds rather than days. This empowers momentum investors to invest by using technical analysis. Technical analysis is “the study of relationships among security market variables, such as price levels, trading volume, and price movements, so as to gain insights into the supply and demand for securities…Technical analysis attempts to determine the market forces at work on a certain security or on the securities market as a whole (Scott).” The volatility—defined as the variance of price levels,—creates patterns in prices, trading volume, and correlation between one security to another. These patterns are fascinating to technical analysts. By recognizing these patterns and betting on their repetition, technical analysts could potentially earn handsome profit. However, technical analysis involves frequent transactions and ignorance to the economics of a business.
Value investing, on the other hand, does not have these restrictions. It is primarily driven by fundamental analysis. Fundamental analysis is an “analysis of security values grounded in basic factors such as earnings, balance sheet variables [including debt-to-asset ratio, inventory turnover rate…], and management quality… [It] attempts to determine the true value of a security, and, if the market price of the stock deviates from this value, to take advantage of the difference by acquiring or selling the stock (Scott).” Value investing focuses on generating long-term returns from buying underpriced securities. Value investors believe the fundamentals of a business including industry outlook, cash generating ability, management expertise, and pricing strategies would eventually be reflected in the stock price. They are always trying their best to define value, find the value they defined, and purchase the value at a bargain. Some investors define value as the liquidation value of a company which is the total worth of the company’s physical assets if it were to go out of business. Other investors define value as GARP, or growth at a reasonable price, which involves looking for companies that are showing consistent earnings growth above broad market levels. After identifying the values in the market place, value investors only purchase these values if they were underpriced to minimize risk.
Unlike momentum investors who wager their wealth on many assumptions, value investors wager their wealth on only one assumption: although the market is volatile and unpredictable in the short run, it reflects the performance of underlying businesses in the long run. The two investing methodologies are opposite because value investors look for assets that are underpriced because of momentum investors’ over-reliance on patterns.
In fact, an investor would be better off being a value investor than a momentum investor for four reasons. Firstly, value investing entails bottom-up research for fundamental analysis and bottom-up research is usually more manageable than top-down research. Secondly, value investing does not incur frequent transactions. Thus, value investing helps investors save on transaction cost. Thirdly, value investors do not have to deal with the volatility of the market. Although value investing requires substantial ability to stand discomfort and patience, the focus on intrinsic value allows value investors to stay away from those uncertainties. Lastly, value investing encourages buying at a discount to the intrinsic value of the security. This creates a “margin of safety” or a cushion that allows price to drop slightly further without realizing a loss. This safety net, in combination with strong fundamentals of a business, is the best way to protect and develop wealth in the long run.
“Generally, investors begin their search for attractive candidates [for investment] in one of two ways: top-down and bottom-up (Brandes).” Top-down investors start broadly and narrow their search gradually. They first gauge the strength of the economy in a particular region and identify an industry of strongly positive prospect. They then study the economy’s historical performance to help find a promising sector. Factoring in expectations of macroeconomic dynamics such as interest rates, political climate, and foreign exchange rates, top-down investors then determine specific stocks that will fit their investment thesis. This approach involves a series of assumptions. If any of these assumptions is slightly inappropriate, the investment would be unappealing (Brandes).
Bottom-up investors, on the other hand, evaluate thousands of individual business simultaneously. They analyze the earnings and cash generating ability of each company as a ratio of its market price in order to find the most attractive candidates. Less consideration is given to macroeconomic factors. Clearly, this is more manageable than top down research. Neither expertise of investing nor confidence in forecasting is needed. Seth Klarman, president of The Baupost Group, stated in his book Margin of Safety, “in reality, no one knows what the market will do; trying to predict it is a waste of time, and investing based upon that prediction is speculative undertaking (Klarman).” Seth Klarman is a legendary fund manager for The Baupost Group. Since its inception in 1982, the fund has returned over 20% per year on average and manages $22 billion as of 2010.
So why do momentum investors favor top-down research? They believe that “bottom-up investing is poorly suited to the current era, as it fails to equip investors with the many tools they need in order to spot opportunities throughout the globe…[it is] for those who want to think small and prefer to shun the extraordinary investment opportunities created by the spread of market capitalism. Top-down investing is for those desiring to think big, and it is for profit (Crescenzi).” We have to recognize that bottom-up investors might lack the tools they need to pinpoint attractive investments because in the globalized village, we have to account for different accounting standards and legal implications in different regions in order to find the most attractive businesses. Moreover, we need to understand different languages ahead of everything else. However, we could overcome these difficulties through outsourcing and hard work. Bottom-up investors do not prefer to “shun extraordinary investment opportunities.” They are simply more risk-averse. Unlike top-down investors who trust their gut feelings and have faith in their abilities to “think big,” bottom-up investors only depend on hard work to analyze all investment opportunities. Top-down investors’ accusations do not make value investing any less attractive if an investor is willing to work hard.
Bottom-up research is a better method to make investment decisions because it is more pragmatic. To answer the yes-no question of whether we should invest in a company, we only need to analyze its business and compare it to its competitors. On the contrary, top-down analysis requires assumptions that could falter. Therefore, bottom-up research-based value investing is better than top-down research-based momentum investing.
Value investing has a long-term focus. Its disciplines “focus on long-term fundamentals and reject all technical charist approaches… [It has] long-term investment strategies and short-run operating results in analyzing companies (Whitman).” The long-term focus leads to fewer transactions.
Momentum investors focus on being the first movers. They would buy a security before everyone else does if they believe the prevailed market perception indicates the security would increase in value. Similarly, they would try to sell a security before the momentum of selling accumulates. Since the market continuously drifts up and down, momentum investors have to transact with brokers very frequently. Each transaction comprises a direct transaction fee to compensate the broker-dealer and an indirect cost that is reflected in the bid-and-ask spread. The transaction fee ranges from 0.5% to 5% of transacting value. In very rare cases the fee lands on the lower end because there is a lower bound on the fee. Therefore, unless you buy or sell a multi-billion-dollar block of shares, your transaction fee would be high. The bid-and-ask spread is the difference between highest price a broker is willing to buy and the lowest price a broker is willing to sell. This translates to an immediate loss if you were to buy and sell a share simultaneously. The spread ranges from one cent to a few dollars per share. It exists simply to protect brokers from market volatility. High market volatility is associated with wider spread. In other words, if stock A traded between $10 and $20 in the past year, stock B traded between $14 and $16, and both have fair price at $15, the bid and ask for stock A might be $14.2 and $15.8 while the bid and ask for stock B might be $14.9 and $15.1. The bid-and-ask spread creates an indirect cost for investors. Thus, if an investor were to buy 100 shares of stock A at $15.8 and pay his broker $10 dollars for the transaction, he would have to wait for the stock to increase 6%1 and reach $15.92 per share before realizing any positive return.
Robert A. Korajxzyk and Ronnie Sadka conducted research to “test whether momentum strategies remain profitable after considering market frictions induced by trading (Korajxzyk).” Their study showed that returns generated by momentum strategies decline with portfolio size. In other words, the return to capital deployed in momentum investing has diminishing returns to scale.
Value investors, with a long-term focus, neither need to face the frequent transaction costs nor do they need to face diminishing returns to scale. Value investors often hold a stock for years unless the underlying business undergoes an imperative negative clause. The low frequency saves value investors transaction costs.
Value investors also do not need to deal with the volatility of the market. The focus on intrinsic value allows investors to stay away from most of the uncertainties. Numerous researches showed that short-term price movements are similar to random walks. French mathematician Pioncare “found that each period’s price change was not significantly correlated with preceding period’s price change nor with the price change of any earlier period, at least as far as he tested, up to twenty-nine periods (Alexandra).” This means the change in price of a stock cannot be explained by any previous changes.
Thus, relying on historical price performance to predict future price movement is a gamble. Momentum investors have to buy at lows and sell at highs in the volatile market. Just as a gambler with sophisticated knowledge of probability bets on heads-or-tails on the next coin flip, a momentum investor with expertise in top-down analysis bets on direction of price movement. Contrary to this, a value investor never takes bets. A value investor is armed with almost all, if not complete, knowledge of a company when he makes the investment decision. He knows the company’s comparative advantage, industry prospect, profit margin, leverage ratio, the risks associated with its business... Most importantly, he only invests if it is a bargain. Then, all he has to do is to wait for the market price to reflect the true value of the company.
“Patience is a key virtue for a value investor. As Ben Graham said, an undervaluation caused by neglect or prejudice may persist for an inconveniently long time (Monitier).” That is to say that price might drop further in the short run simply because the market is irrational. Similar to any individual in an uncomfortable situation who would implement a fight or flight decision, a value investor in price drop would either average-down or sell off. Namely, a value investor would either buy more at lower price after a price drop to lower his cost basis for the stock or sell all the shares he owns because price drop makes him uneasy. Ability to bear low comfort levels and patience to wait for the market to reflect the true value are extremely essential.
Now you might wonder, what is the catch? What distinguishes value investing and leads to handsome returns? “Warren Buffett likes to say that the first rule of investing is ‘Don’t lose money,’ and the second rule is, ‘Never forget the first rule.’” Even though no one wishes to incur losses, the innate compelling urge for free lunch through speculation in every single human being is evident. Some investors believe “risk comes, not from owning stocks, but from not owning them,” or “risk avoidance is incompatible with investment success (Klarman).” These conceptions might sound silly but they are widely believed.
The next question is: how do we minimize losses in investments? “Value investing is the discipline of buying securities at a significant discount from their current intrinsic values and holding them until more of their value is realized (Klarman).” Bargain is the key. For value investors, it is translated to buying a dollar for fifty cents and waiting for others to realize it is, in reality, a dollar.
We all love bargains when we shop for foods, clothes, and electronics. We can easily get excited when we see a poster that says “50% off of everything.” But why are we not excited about bargains in stocks? This is because not following the herd makes us feel anxious. A contrarian is very lonely and uncomfortable. It is much easier to endure losses when everyone else experiences losses than to be value investor and experience disastrous performance when others enjoy gains. That is why patience is needed for true value to be reflected in the price.
The discount in purchase price provides a margin of safety. “When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And the same principle works in investing (Willis).” This is the core concept in value investing.
Overall, value investing is a better practice than momentum investing. This is because a more manageable research method,is employed. While momentum investors incur frequent transaction costs, direct and indirect, and cope with the volatile market, value investors seek discounts that provide margins of safety. While momentum investors aim to ride on trends for free lunch, value investors work meticulously to find bargains. Fortunately, all of the hard work could pay off and the long-term wealth value investing delivers is palpable.
The world’ third richest individual, Warren Buffett, a self-made value investor of personal net worth of $47 billion, has once said, “we’ve long felt that the only value of stock forecasters is to make fortune tellers look good… [I] believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children (Altucher).” His analogy between momentum investors and children indicates that trend predictors are believed to be immature. Warren Buffett is only one of many investors who earned their fortunes through value investing.
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Footnotes:
1. [($15.8*100+10)/ ($15*100)-1]*100% = 6%.
2. $15*(1+6%) = $15.9
