The stock market's recent rise could make portfolio management more challenging. Soaring stock prices mean some companies may now be overvalued. They could also face an uncertain future due to economic and political risks.
In my opinion, a value investing strategy could be a useful ally in the current market. It may improve the efficiency of your capital allocation and help you to avoid unnecessary risks.
Therefore, following the advice of value investors such as Joel Greenblatt (Trades, Portfolio) could be a good idea. His focus on estimating the intrinsic values of quality businesses may be a key reason behind his long-term investment success.
Focusing on intrinsic values
In my view, it is more difficult to estimate the value of a company now than it has been in recent years. A fluid economic outlook means that asset prices are subject to major change, while earnings forecasts may prove to be very different to actual results.
However, working out the value of businesses prior to purchase is still possible. For instance, using a company's average financial performance over the past five years could offer guidance as to whether it is trading at a premium or discount to its intrinsic value. This may provide a more accurate picture of a company's worth when compared to using this year's disappointing results, which could prove to be exceptional.
Buying stocks for less than their intrinsic value may lead to a more efficient allocation of capital. Growth strategies may have outperformed value investing strategies in recent months. However, value investors such as Greenblatt have a long track record of beating the market. As he once said, "The secret to investing is to figure out the value of something - and then pay a lot less."
Investing in the best opportunities
Rising stock prices in this bull market may mean there are a limited number of undervalued opportunities within your circle of competence. However, this should not encourage you to invest in overvalued stocks, or in companies with weak fundamentals.
A more productive use of your capital could be to invest only in your best ideas, and hold cash while you await more buying opportunities. This may allow you to take advantage of today's mispricings and be in a position to quickly react should market volatility increase in future.
This strategy does not mean you should forget about diversifying your portfolio. Having a range of companies in your portfolio can reduce unsystematic risk, which is the risk inherent in a specific company or industry.
Greenblatt has always allocated capital to his best ideas and patiently waited for more buying opportunities to appear in future. As he once said, "Remember, it's the quality of your ideas not the quantity that will result in the big money."
Taking risks into consideration
It is easy to overlook risks when investing in a bull market. Rising stock prices can tempt you to focus on potential rewards from your investments, rather than the possibility that they will deliver a permanent loss of capital.
However, no bull market has ever lasted forever. This means that planning for the next bear market now could be a prudent move. For instance, buying undervalued stocks may protect your portfolio from market-wide declines. Likewise, buying companies with sound fundamentals could limit your losses in a period of economic weakness.
Greenblatt has always had risk at the forefront of his mind when managing his capital. As he once said, "Look down, not up, when making your initial investment decision. If you don't lose money, most of the remaining alternatives are good ones."
Read more here:
- Seth Klarman on Risk Versus Reward
- Peter Lynch on Deciding Where to Invest Your Capital
- Howard Marks: History Can Be a Useful Guide in Today's Market
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