8 principles of valuation-driven investing

By Morningstar |  08-09-20 | 
 

Valuation-driven investing is simple: find the fair value of an investment, and buy it only if the price is sufficiently below that fair value to provide a margin of safety against error. Then sell it when the price is significantly above the fair value of the investment.

Simple, but not easy. Dhaval Kapadia, Director – Portfolio Specialist at Morningstar Investment Advisers India, has some practical suggestions on how to go about it.

What helps valuation-driven investors reach their goals is a process they can stick to that gives them the confidence to always stay the course.

Find the right opportunities

This requires a consistent valuation framework for estimating the fair value of an asset. It also requires a willingness to consider out-of-favour assets. Some of the greatest value opportunities often lie in unglamorous markets, sectors or in companies that have recently experienced bad news, but remain fundamentally strong.

Do the fundamental research

You need to be able to distinguish the low-priced assets that will likely recover (the bargains) from those that will likely not (the value traps). You will need to analyse the investment’s fundamentals and pay close attention to its qualitative characteristics, such as its underlying growth drivers and governance, to determine whether these characteristics indicate it’s a sound investment.

Stay mentally tough

Cheap assets or markets tend to be unpopular. Valuation-driven investors must avoid being swayed by other investors’ sentiments or market trends. That’s why it is so critical to build a solid investment process that includes a rigorous valuation framework and an insistence on a substantial margin of safety. This will help you give the confidence to stick with your decisions, as well as the willingness to change them when circumstances change and an asset no longer appears attractive.

Play the long game

Buying an undervalued asset is only the beginning. It may take a considerable period of time for an under-priced asset to return to its fair value. Investors must be willing to hold investments for many years. Don’t waste time thinking about unrealised profits or losses along the way. The market only really matters at two points: when you enter and when you exit.

Worth mentioning is that a valuation-driven approach cannot help investors or portfolio managers predict short-term returns or avoid short-term losses. It is intended solely as a strategy that strives to deliver superior long-term returns. It can help investors of all kinds define the different possibilities open to them, potentially determine realistic estimates of future returns and losses, and identify which assets are most attractive at their current prices.

Wait for the right moment

Markets do not always offer the same number or quality of opportunities. There are periods in the market cycle when prices are low and opportunities are plentiful and other periods when prices are high and opportunities are scarce. If investors cannot find assets that offer good value, they should consider conserving cash and wait for more-attractive opportunities, rather than commit capital to lesser opportunities with limited prospects.

Avoid trading too much

Many investors believe that activity is good and low turnover in a portfolio is a sign that the manager is not making decisions. In reality, exceptional opportunities can be rare, while active trading boosts costs that act as a big drag on returns. Many successful valuation-driven investors devote as much time as possible to research and as little as possible to buying and selling.

Hold a range of return drivers

A portfolio that depends too heavily on a single factor to drive returns effectively becomes a forecast of that factor. For example, returns for a portfolio concentrated in energy stocks will be too dependent on oil prices. Such factors are often very difficult or impossible to forecast accurately. So investors should aim to fundamentally diversify their portfolio among different markets and securities in such a way that returns will be driven by a range of unrelated factors.

Embrace Volatility

For the valuation-driven investor, periods of high volatility represent the best opportunities for their fair value. At the same time, bargains become scarce during periods of low volatility, when valuation-driven investors tend to take a buying break. In contrast, investors who use volatility as a proxy for risk shun bargains in volatile markets and enthusiastically purchase overpriced assets when volatility is low, eating into their returns as a result.

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