No Flawless Investment Strategy

Value investing is supported by both empirical evidence from financial theory and real-world case evidence, such as the legendary stories of Benjamin Graham and Warren Buffett that have formed investment myths.

However, the successful experience of value investing is not universally applicable to all value investors.

It is easy to see how Buffett has succeeded, but it is difficult for an investor to replicate his success.

For any investor, there may not be a so-called "optimal option."

Therefore, we need to choose the strategy that best suits us to adapt to this volatile market, and then it is possible to survive for a long time.

Aswath Damodaran is one of the world's renowned valuation experts.

Years ago, we read his book "Investment Principles: Successful Strategies and Successful Investors."

Now, CITIC Press has reprinted it and renamed it "Investment Philosophy: Successful Strategies and Valuation," which is worth reading again.

Damodaran has put forward insights on value investing and growth investing, which still have a profound impact on us.

Different strategies of value investors are those who look for bargains.

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Some value investors use specific criteria to screen for stocks they believe are priced below their actual value and invest long-term; some value investors believe they can find bargain stocks after a stock price crash; some value investors take an active approach, buying large amounts of stocks of listed companies that are priced below their actual value and poorly managed, and then work hard to promote changes that can release the actual value of the stocks.

Value investing is supported by both empirical evidence from financial theory and real-world case evidence, such as the legendary stories of Benjamin Graham and Warren Buffett that have formed investment myths.

However, the successful experience of value investing is not universally applicable to all value investors.

The difference between value investors and other investors is that they expect to buy company stocks whose existing asset value is higher than its price.

Therefore, value investors are generally more cautious about stocks that pay a large premium due to growth opportunities, and they strive to find the cheapest stocks in companies that have fallen out of favor and are more mature.

Based on this, Damodaran found that there are two distinct categories in value investing: passive screening and contrarian value investing.

Passive screeners divide investments that pass some investment screens, such as low price-to-earnings ratios, market value, and extremely low risk, into good investments.

Passive screeners believe that stocks with certain characteristics - well-managed, low risk, high-quality earnings - will perform better than other stocks.

The key to investment success is to identify these specific characteristics.

They are always looking for these characteristics, and Graham transformed these qualitative characteristics into quantitative screens that can be used to find promising investments in his classic work "Security Analysis."

Although the items screened in "Security Analysis" vary in each edition, they basically maintain the original form: the ratio of income to price must be double that of AAA bonds; the price-to-earnings ratio of stocks must be lower than 40% of the average price-to-earnings ratio of all stocks in the past five years; dividend income > 2/3 of AAA corporate security income; price < 2/3 of tangible book value; price < 2/3 of net working capital value, net working capital refers to current assets, that is, cash minus current liabilities; the debt-to-equity ratio (book value) must be less than 1; current assets > twice current liabilities; debt < twice current assets; the growth rate of earnings per share in the past (over the past 10 years) > 7%; the number of years with declining earnings in the past 10 years should not exceed 2.

Graham believed that any stock that passed these 10 screens was worth investing in.

Henry Oppenheimer studied the stock portfolios obtained from these screens from 1974 to 1982 and concluded that you could get an annual return that is much higher than the market.

At the beginning of the 21st century, the academic community tested various screening factors - such as low price-to-earnings ratios and high dividend income - and found that these screens did indeed produce investment portfolios that increase returns.

Mark Hulbert evaluated the performance of investment newsletters and found that those that believe and follow Graham's screens indeed performed better than other investment newsletters.

However, the only discordant note was the attempt to transform Graham's screens into mutual funds that provide high returns failed.

In the 1970s, a man named James Ray, who fully believed in the value of these screens, created a fund that invested in stocks based on Graham's screens.

Although some initial investments were successful, the fund fell into trouble in the 1980s and early 1990s.

The greatest support for Graham's value investing came from his students at Columbia Business School.

Although these students chose various paths, most of them achieved great success.

Among them, the most outstanding student is Warren Buffett.

Damodaran believes that Buffett's continuous success cannot be simply attributed to luck.

The secret to his success lies in his long-term development vision and his discipline - not changing investment principles due to short-term losses.

In fact, Buffett's investment strategy is much more complex than Graham's original passive screening method.

Unlike Graham's conservative investment principles, Buffett's investment strategy extends to more diversified companies, from blue-chip stocks to Coca-Cola to Apple.

Although both Graham and Buffett use screening methods to find stocks, the main difference is that Graham strictly follows quantitative screening methods, while Buffett is more willing to consider qualitative screening methods.

Interestingly, Buffett's investment method is not actually complex.

But we do not see other investors using his method to replicate his success, because, first, the market has undergone tremendous changes, and Buffett's greatest success occurred in the 1960s and 1970s.

Damodaran believes that if Buffett started again under today's market conditions, he would also find it difficult to replicate his past success.

Second, in recent years, Buffett has adopted a more active investment style and has been successful.

But as an investor to be successful in this style, a large amount of resources and credibility required for successful investment are needed.

Third, if the characteristics of the macroeconomy have undergone fundamental changes, then taking Buffett's strategy of buying good companies at low prices and holding them for a long time may not bring the ideal results of the past.

Finally, patience.

Buffett buys companies that are beneficial in the long run, and he is often willing to hold stocks that he thinks are undervalued due to bad years, and endure years of low prices.

In short, it is easy to see how Buffett has succeeded, but it is difficult for an investor to replicate his success.

Contrarian value investing buys assets that other investors have not touched because of poor past performance or bad news.

It is based on the market's overreaction to good and bad news.

In the long run, stocks that have performed particularly well or particularly poorly in a certain period generally show the opposite situation in the next period, but the period cycle should not be weeks or months, but years.

Contrarian investing takes many forms, among which the most important are buying losers and expected value games.

Damodaran proved in the form of negative serial correlation that stocks themselves will reverse after a long time.

Stocks that have declined the most in the past five years have a greater chance of rising than other stocks.

In 1985, Richard Thaler and Werner De Bondt in their paper "Does the Stock Market Overreact?"

proposed one of the most important findings in behavioral finance: on a cycle of 3-5 years, stocks that have performed poorly originally began to get out of trouble, and the original winner stocks began to decline.

The study shows that these findings may be very meaningful, but may overstate the potential return rate of the loser portfolio, for the following reasons: First, the loser portfolio is prone to uneven distribution of returns, that is, excess returns come from a few stocks with particularly good returns, rather than the overall performance of the portfolio.

Second, when the stable scale cannot be controlled, loser stocks perform better than winner stocks; when the market value ratio of the two is quite similar, the former performs better than the latter only in January.

Third, although prices may reverse over a long period, if the short term is considered, there is a price trend where loser stocks often continue to lose money and winner stocks continue to make a profit.

There are also two interesting findings in their study.

In the first 12 months, the winner portfolio actually performed better than the loser portfolio; although the loser stocks began to catch up with the winner stocks after 12 months, in 1941-1964, it took 28 months to surpass the winner stocks.

In 1965-1989, the loser stocks even took 36 months and did not start to surpass the winner stocks.

The benefits of buying loss-making companies mainly depend on whether you have the ability to hold these stocks for a long time.

Any investment strategy that buys well-operating companies and hopes that the growth of these companies will drive up their prices may be dangerous, because it ignores the possibility that the current price has already reflected the quality of the company's management and assets.

If the current price is correct, the biggest danger is that over time, the company will lose its luster, and the rewards given by the market will be exhausted.

If the market overstates the value of the company, even if the company is growing, the investment strategy will lead to poor returns.

Only when the market underestimates the quality of the company can the strategy earn excess returns.

Investing in well-managed companies does not always make money.

Tom Peters summarized some of the characteristics that make outstanding companies stand out from all companies in the market in his "In Search of Excellence."

The financial condition of outstanding companies may be better than that of non-outstanding companies, but non-outstanding companies are at least a better investment than outstanding companies during the observation period.

Although the study did not consider risk factors, the investment period is insufficient, but it provides evidence that good companies are not necessarily good investments, and bad companies can also be good investments.

This is also what Howard Marks meant by "buy well rather than buy good.

"Poor performance does not necessarily mean poor management.

Many companies in industries that have been in a long-term slump with no sign of a turnaround could still underperform in the future.

However, if other companies in the same industry as the underperforming company are doing well, then the chances of success might be higher.

There is potential for improvement in a company before we can see an increase in stock prices.

Risk-averse investors who wait for the lowest price to invest cannot adopt this strategy because determining the right timing is almost impossible.

We must accept the fact that some poorly managed companies may get worse before they get better, and this scenario could damage the investment portfolio in the short term.

Therefore, buying stocks of losers or poorly managed companies does not guarantee success, and this strategy may prove to be impractical.

Unless investors have a long-term investment horizon, diversify their investments, and possess good personal qualities, that's another story.

Strategies have their advantages and disadvantages, and like value investors, growth investors also value value, but the key difference lies in where they find it.

Value investors believe they are more likely to find assets that are underpriced by the market and are more willing to invest in mature companies with a large amount of existing assets but poor performance.

Growth investors believe they are more likely to find cheap stocks in growth investments.

The most effective way to build a portfolio is to screen and select stocks that pass specific screening criteria.

There are three screening strategies for growth investing: high growth rate stock strategy, high P/E ratio high-risk strategy, and growth at a reasonable price strategy.

High earnings growth strategy, this is the most reasonable strategy followed by most growth investors to buy stocks with high earnings growth rates, but this strategy has uncertainties, and past growth rates do not necessarily accurately represent future growth rates.

Past growth rates help predict future growth rates, but there are two problems with past growth rates: First, for many companies, if past growth rates are not reliable indicators of future growth, it is impossible to rely on them to predict the future.

Moreover, the growth rates of small companies are more volatile than those of other companies in the market.

Therefore, past earnings growth rates should be used cautiously to predict a company's future earnings growth.

Second, companies that are rapidly developing today will slow down and approach the market average development level, while the growth rates of companies below the market average development level will rise.

Although in the year the investment portfolio was formed, the average growth rate of companies with the highest earnings growth may be higher than the average growth rate of companies with the lowest earnings growth, but after 5 years, this difference can be negligible.

Generally speaking, revenue growth is more sustainable and predictable than earnings growth.

But past earnings growth is not a reliable basis for predicting future growth.

Investing in companies with high past growth does not produce high returns.

If mean reversion exists, and investors buy stocks of high-growth companies at a premium, they will later find that their investment portfolio is losing money.

The intrinsic value of a stock is ultimately affected by future growth rather than past growth.

Therefore, it makes sense to invest in stocks with high expected future growth value rather than stocks with large past growth.

But in the securities market, we cannot estimate the price of every stock in the market.

If this strategy is to be successful, it is necessary to be good at predicting long-term earnings growth; market prices should not have already reflected this growth or priced it too high.

If investors believe that the growth of growth companies will bring excess returns in the future, then the easiest and riskiest strategy is to buy the stocks with the highest price-to-earnings ratios in the market, which is a high P/E ratio.

However, Damodaran points out that the total evidence for buying high P/E ratio stocks is brutal.

He has already pointed out when examining value stocks that buying low P/E ratio stocks seems to perform much better than buying high P/E ratio stocks.

So, what attracts investors to adopt a high P/E ratio strategy?

The answer is the investment cycle.

When the market's earnings growth is low, growth investing seems to perform much better, while value investing tends to perform better when the earnings growth rate is high.

In years when the earnings growth rate is low, growth investing performs best, which may be because growth stocks are scarce during this period.

The most interesting evidence for growth investing is the percentage of fund managers who beat their own indices.

When measured according to their own indices, the number of times active growth investors beat the growth index seems to be more than the number of times active value investors beat the value index.

For investors who are afraid of buying high P/E ratio stocks, their principle is to buy high growth stocks that are priced low for growth.

This involves two strategies: buying stocks with a P/E ratio lower than the expected growth rate or buying stocks with a low P/E to growth ratio (PEG).

P/E ratio is lower than the growth rate.

If a stock's price-to-earnings ratio is 12% and the expected growth rate is 8%, then the stock will be considered overpriced; but if the price-to-earnings ratio is 40% and the expected growth rate is 50%, then the stock will be considered underpriced.

The obvious advantage of this strategy is simplicity, but it also has potential dangers for the following two reasons.

First, interest rate impact.

Since growth creates future earnings, the value of growth should be present value.

When interest rates are low, the value created by any growth rate is greater than when interest rates are high.

Therefore, a stock with a price-to-earnings ratio of 40% and an expected growth rate of 50%, when interest rates fall to 5% and the growth rate remains unchanged, its price-to-earnings ratio is 60%.

Second, growth rate estimates.

When using this strategy in a large number of stocks, you have no choice but to use the growth rate estimates of other stocks.

Given the fact that the estimated growth rate is at most 5 years, if you only focus on the 5-year growth rate, it is disadvantageous for companies with expected growth rates much longer than 5 years.

In low interest rate situations, few companies can pass the screening, and the result is that there are almost no stocks to invest in.

P/E to growth ratio (PEG).

It is generally believed that stocks with a low PEG ratio are cheap, because less is paid for growth, so it can be seen as a utilitarian measure to compare different rates of return.

Research has found that the returns obtained from the strategy of buying stocks with a low PEG ratio are much higher than the returns obtained from investing in the S&P 500.

However, if stocks with a low PEG ratio perform better than other stocks, why not use it as a screening indicator?

This is because there are two potential problems with the PEG ratio, which may lead us to mistakenly consider stocks with high growth rates and high risks as underpriced stocks.

The first problem is that the PEG ratio is calculated by dividing the P/E ratio by the expected growth rate, and the uncertainty of the expected growth rate is not factored into the PEG ratio.

Therefore, stocks that appear cheap according to the PEG ratio may in fact be correctly priced or overpriced.

The second problem is that when using the PEG ratio, we have an ambiguous assumption that if the growth rate doubles, the P/E ratio also doubles; if the growth rate is halved, the P/E ratio is also halved.

Assuming a linear relationship between the P/E ratio and the growth rate is wrong.

When the expected growth rate is low, the PEG ratio is the highest, but when the expected growth rate increases, the PEG ratio decreases.

The problem is most serious when comparing high-growth companies with low-growth companies, because the PEG ratio of high-growth companies is underreported, while the PEG ratio of low-growth companies is overreported.

As a result, growth investors must make more accurate estimates of growth.

The success of growth investing ultimately depends on the ability to predict growth rates and price correctly.

If you can outperform the market in this regard, you can increase your chances of success.

Historically, growth investing has performed best when market earnings growth is low and investors are pessimistic about the future.

However, to be a growth investor, one must accept skewed returns in the short term (i.e., returns that are either greater than the mode or less than the mode) and invest in the right companies.

Any strategy has its advantages and disadvantages, and there is no infallible best strategy.

For any investor, there may be no so-called "optimal option."

If you apply it rigidly, you cannot succeed.

Dogmatism can only lead us into one trap after another.

Therefore, we need to choose the strategy that suits us best to adapt to this volatile market, and then we may be able to survive for a long time.