The term "value investing" seems to have become one of the world's most misused descriptive statements. As plenty of research has shown that value stocks generally outperform the market over the long term, investors have flocked to the style over the years, and now any mention of a particular value stock is enough to attract the attention of investors all over the world.
This means that "value stock" is now thrown around for any equity that appears cheap, which just isn’t what value investing is based on.
Many of the equities mentioned in such articles are only cheap relative to historic price action, which would alarm the inventor of value investing – Benjamin Graham.
The problem with value investing today
This is the problem value investors now face. Value has become such a widely followed style that any true value stocks quickly become overbought – something Seth Klarman mentioned in his year-end 2016 letter to Baupost investors.
The problem is that value investing has become an abused topic. Value hunters no longer chase deep discounts to intrinsic value. Instead, many estimates of intrinsic value are calculated using inflated figures to justify current share prices, a method of investing that is bound to end in disaster. The market’s recent decline is an excellent example of the wave of enthusiasm sweeping through the ranks of investors. Even though the Standard & Poor's 500 is only around 50 points of its all-time high (less than 3%) market commentators, investor forums and stock tipsters are declaring that now is the time to buy as it is best "to be greedy when others are fearful" and other such Warren Buffett (Trades, Portfolio) quotes.
Such investor optimism and even euphoria is only usually seen at the peak of markets. There seems to be little bearish commentary being published nowadays, which in itself is a tell-tale warning sign that the markets have become too overoptimistic. Investors seem willing to buy at any price and are not fully considering the possible downside if things don’t go to plan.
However, as any seasoned investor will tell you it is impossible to predict what the future holds for markets; while it may appear as if investors have gotten ahead of themselves, there’s no telling how much longer the current rally can last.
What's next
What’s the best course of action then? Is it time to sell and go to cash or remain invested and hope for the best? The answer to this question depends on your personal risk tolerance. If the market does collapse, there will be a real test of investors' nerves, and those who’ve quoted Buffett in the past and believe themselves to be true value investors will be given a baptism of fire. It’s likely many such investors will not have lived through such aggressive declines before.
Reading about and actually experiencing a market drawdown of 20%, 30% or 60% are two extremely different experiences. A drawdown of 60% puts extreme psychological and financial pressure on investors, the kind of pressure for which it’s difficult to prepare.
The best way to prepare for such drawdowns is with virtual experience. Reading studies of how markets reacted and how famous investors traded during the market’s previous crashes will yield some insight into how you should respond.
At the same time phoning a portfolio of deeply discounted securities should protect you from the worst volatility.
When I say "deeply discounted securities" I mean the companies trading at a discount to book value, that are already in the early stages of a turnaround and are not reliant on a buoyant market environment to head higher. Businesses that have solid, improving fundamentals are the best investments here as it is likely their shares will continue to rise irrespective of what the wider market environment is.
Start a free seven-day trial of Premium Membership to GuruFocus.
