The market can overvalue as well as undervalue companies -- so how can investors profit from these two situations?
I used to put a lot of time and effort into finding good value situations to invest in. Then after waiting ages in some cases for the value to 'out', I would sell in a trigger-happy frenzy because the company's valuation matched my view of what was 'fair'. Then I often had plenty of time to watch from the sidelines as the share price shot off into orbit without me!
Traditional value investing
I am a big fan of value investing and after doing my own research typically buy shares in companies with any one or all of the following attributes:
- high dividend yield.
- low price to earnings ratio.
- low price to book value.
- low price to cash flow ratio.
Having bought shares when they are cheap, I wait for the value to 'out' and the shares to return to a level which represents fair value for the company. Often, but not always, this process will involve a rise in the share price which will provide a return on my investment. Sometimes the anticipated re-rating occurs quite quickly and sometimes it takes months.
Traditional value investing wisdom suggests that I should sell my value shares when their price represents fair value for the company. However, on many occasions when I have done this, the shares have gone on to rocket upwards to levels that many would consider to be way above fair value.
Momentum and trends
Richard Farleigh suggests why this might happen in his book 'Taming The Lion'. He argues that markets move:
- in trends.
- further than you may believe possible in either direction.
It is frustrating to watch share prices appreciating so much after selling them particularly when you have waited an age for the value to 'out' -- so now I follow a different approach.
Instead of selling at fair value, I place a trailing stop loss at fair value. (In other words, the shares are sold as soon as the price falls below fair value.) I either place the stop loss in my head mentally, or physically with a broker. I then allow that to take me out of the investment. In this way, I stand a chance of benefiting from any overvaluation that the market is offering.
Normally stop losses are not a good idea in my view. Often they can stop you out of later gains following a temporary weakening of the share price. This is particularly so for value investing where faith in your own analysis is what is required. However, in this scenario, and after profit is available in the investment for 'locking in', I believe that they make sense.
Maximising value
As a value investor, I see my job as being that of profiting from valuation anomalies that the market may throw up from time to time.
However, just as the market undervalues companies so it overvalues them too. It makes sense for me to take advantage of both of these opportunities and not just one. A lot of effort goes into finding companies that are undervalued to invest in, so optimising the gain from that investment optimises the use of my investing time.
