7 tips for valuation driven investing

By Morningstar |  22-06-22 | 

At its core, valuation-driven investing is a straightforward process: find the fair value of an investment, buy it if the price is sufficiently below that  fair value. Then sell it when the price is significantly above the fair value of the investment.

But our ability to make wise investment choices is often clouded by several competing forces: investor biases, overconfidence, and the tendency to "find" evidence that confirms our views and put undue focus on recent performance. It is these challenges, as well as our mind’s ability to steer us off course, that valuation-driven investors seek to overcome.

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

We have identified seven tips to help keep valuation-driven investors focused on meeting their long-term goals, even when market changes threaten to distract them. 

1. Find the right opportunities

This requires a consistent valuation framework for estimating the fair value of an asset and a systematic search process. Many of the greatest value opportunities lie in unglamorous industries, niche markets, or companies that have recently experienced bad news but remain fundamentally strong. Only by using a systematic screening process will you be able to overcome the market noise and expectations driven by recent price movements.

For valuation-driven investors to succeed, they must do so unconventionally. They must overcome their biases and often take actions that directly contradict the views of their peers.

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2. 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).

Fundamental analysis is the heart of successful investment and the focus of great investors. As the fair value of an asset is determined by its future cashflows, fundamental analysis must combine a deep understanding of the drivers of that cashflow—as well as any associated risks (appreciating what could go wrong) and the subsequent probability of potential outcomes.

Analyse the investment's financial statements and pay close attention to its qualitative characteristics, such as its underlying business model and governance, to determine whether these characteristics indicate a sound investment. Examining the current price, the investor is able to use the results of this analysis to estimate the attractiveness of the asset relative to other opportunities.

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3. Play the long game.

Valuation is seldom an indication of near-term market movements.

Buying an undervalued asset is only the beginning. It may take a considerable amount of time for an underpriced asset to return to its fair value. Investors must be willing to hold investments for many years.

Underpriced assets are often so disliked by other investors that it can take years for them to be appreciated. However, the change in price associated with their rehabilitation can be so considerable that the wait is worthwhile. Buying an undervalued asset is therefore only the beginning of the investment journey—patience is essential.

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4. Stay mentally tough.

The separation of the fair value of an asset and its price can lead us to learn the wrong lessons when investing. For instance, the price of an asset we hold may rise for reasons that are completely different from our expectations, and yet we feel good about our decisions.

Successful investors ignore the feedback of short-term price changes and focus instead on comparing the progression of the cashflow to their expectations.

Valuation-driven investors must avoid being swayed by other investors' sentiments or market trends. That's why it's critical to build a solid investment process that includes a rigorous valuation framework and an insistence on a substantial margin of safety.

This focus on the process rather than the outcomes will help give you 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.

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5. Think in base rates, not stories.

As humans, we are naturally drawn to familiar narratives. Often these narratives describe the extraordinary rather than the ordinary. This can lead us to unrealistic expectations when we attach a narrative to a potential investment. However, most situations are necessarily ordinary and so it is worth testing our expectations against an ordinary outcome. We call these ordinary expectations base rates, and they are a useful way of remaining grounded as we think about the future.

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6. Avoid trading too much.

Trading not only increases the cost of investment, it can be a sign that the investor is expressing overconfidence in their ability to predict short-term market movements. While some trading is essential to good portfolio management (for rebalancing), and other forms of trading can be supportive of returns (such as tax loss harvesting), all changes must be made with a long-term perspective. Successful valuation-driven investors devote as much time as possible to research and as little as possible to buying and selling.

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7. Build a robust portfolio.

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 oil stocks will be too dependent on oil prices. Such factors are often very difficult or impossible to forecast accurately. Therefore, investors should think carefully about robustness, aiming to diversify their portfolio among different holdings and size them in such a way that returns will be driven by a range of unrelated factors.

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