Some investors may be feeling uncertain about how to manage their portfolios following the stock market’s crash and subsequent rebound in the first half of 2020. Many stocks now have extremely high valuations, but their financial progress could be derailed by substantial economic risks that may be ahead.
Therefore, it could be a good idea to implement a value investing strategy such as that used by Baupost Group founder Seth Klarman (Trades, Portfolio). His focus on business fundamentals and his insistence on obtaining a margin of safety could help you to navigate today’s uncertain market outlook.
Business fundamentals
Some investors may currently be aiming to make a quick return due to the stock market’s high volatility. Equally, they may increasingly rely on forecasts due to the challenging outlook for the economy.
However, a superior means of apportioning capital efficiently could be to take a long-term view of your holdings based on business fundamentals. It is impossible to predict the future performance of the stock market, particularly over a short time period. Therefore, identifying quality companies that are undervalued could be a more reliable and successful means of investing over the long run than relying on forecasts or recent trends.
As Klarman once said, “Individual and institutional investors alike frequently demonstrate an inability to make long-term investment decisions based on business fundamentals.”
Paying attention to risk
It is easy to become overly optimistic during a bull market, just as it can be tough to remain positive in a bear market. Therefore, after the S&P 500’s 40%+ gain since March 23, many investors may be shifting their focus away from risk and towards the stock market’s return potential.
However, it is just as important to consider risks during a bull market as it is during a bear market. Valuations are often higher in a bull market, and the risk of loss could be greater than it is when purchasing stocks that trade for less than their intrinsic value during a bear market.
A value investing strategy encourages an equal focus on risk and reward. Therefore, it can be an effective means of apportioning capital during a variety of market conditions. It may be particularly relevant today when investors face the paradox of high valuations for many large businesses and a highly uncertain economic outlook.
As Klarman once said, “The focus of most investors differs from that of value investors. Most investors are primarily oriented toward return, how much they can make and pay little attention to risk, how much they can lose.”
A margin of safety
The stock market’s recent rise means that investors may be less concerned about company valuations and more interested in their growth stories. This could be detrimental to their long-term returns, since company valuations may already factor in their growth potential.
Therefore, obtaining a margin of safety on any new investment is crucial when seeking to productively allocate your capital. It provides a "buffer zone" between the current price of a stock and its intrinsic value in case estimates about a company’s future earnings turn out to be incorrect.
The margin of safety principle is a key part of value investing. It is a central tenet of Klarman’s investing strategy:
“A margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes. It is adherence to the concept of a margin of safety that best distinguishes value investors from all others, who are not as concerned about loss.”
Read more here:
- Howard Marks on the Importance of Self-Discipline
- Warren Buffett on the Fear of Missing Out After Stock Price Gains
- Peter Lynch on Managing Loss-Making Positions
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