One of the biggest problems with being a value investor is the challenge of trying to tell the true value stocks from the value traps. If a stock turns out to be a value trap, another obstacle comes in the form of trying to determine when to give up.
Value investing is all about finding stocks that look undervalued compared to the intrinsic worth of the underlying business. If investors are following this style, the risk of a security remaining undervalued for an extended period is significantly higher than it would be for other investment disciplines.
For example, growth and momentum investing are linked to share price movements. Companies tend to be labeled growth investments if their share prices have seen significant growth (and momentum investments are only traded if they are going in the direction the investor wants). As a result, investors and traders generally don’t have to wait long for a security to either go in the direction they want, or take an unfavorable turn.
However, value investing, by its very nature, is contrarian. Equities are usually undervalued because the market is moving away from the security for good reason. The chances that the security will continue to decline in value and the market will continue to ignore the value are high.
So, how do investors avoid the problem of getting stuck with a company that appears undervalued at first but just keeps getting cheaper? We can look at the portfolios of the world's greatest value investors to understand how they avoid this issue.
Learning from the best
Starting at the beginning, Benjamin Graham always invested in companies where he could see an opportunity to realize value on the horizon.
It is commonly believed that he invested in cheap stocks and waited for the market to unlock the value, but that is not really the case. When he was managing his investment partnership with partner Jerome Newman, the holdings were mainly bonds and preferred stocks.
The great thing about bonds and preferred stocks is the fact they usually have a payout or realization date. This means one can accurately calculate the potential return in a said period with a high degree of confidence that the value will be unlocked.
With equity investments, Graham often did not wait for the market to realize the value of the stock; instead, he frequently became the catalyst himself by negotiating with the company.
Seth Klarman (Trades, Portfolio), possibly one of the most successful and well-known value investors today, uses a similar approach. His $30 billion hedge fund has approximately 20% of its assets invested in securities, with the rest devoted to bonds and other assets, which generally have a set payoff and value realization date.
An upcoming catalyst
Even when investing in securities, value investors are usually looking for companies that have an upcoming catalyst.
This could be something like a spinoff, an asset sale or a share repurchase authorization, which will ultimately help unlock value and act as a catalyst to drive the market back into the security.
Of course, this strategy does require a lot of work, and it requires patience. What's more, investing in bonds and real assets requires a lot of capital and attention.
If we cannot gain an edge over other market participants, it's likely better to just invest in a low-cost index fund, since trying to pick stocks based on information everyone else has access to means we are just as likely to underperform the market.
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