Why Valuation Matters

Stocks

It’s exhilarating hunting the next stock which could rocket up. You might dig through research reports and finding out which company is leading the way in a futuristic new industry.

Let me stop you before you waste your time.

You’ll likely go through dozens of stocks before you hit ‘the one’, if at all. And those dozens of investments, if you’re lucky, will stay exactly where they start. You might even make a little money on some.

But the vast majority will end up falling significantly.

The reason why is because the market loves a glamour stock — businesses which have huge potential to double, triple, even make 10 times your investment. But because the market loves a glamour stock, it bids up all those stocks it deems to be ‘high growth’.

Therefore, you’re now following the crowd into a stock with a sky high valuation.

But the stock is going to run up to the moon. Who cares what price you pay? Contrary to popular belief, it doesn’t always work out this way. That’s because as glamour stocks trade higher and higher, future growth must be that much more to justify the high price investors are paying.

So what happens when growth doesn’t come to save your investment? Well, just hope you can get out for a small loss, because investors will be looking to get out every which way.

This is why, if you want to be in the market for the long run, you shouldn’t pay sky high valuations. Even if the prospects seem amazing.

Price is what you pay, value is what you get

Instead, focus on what’s real and likely to happen. Nothing is certain in investing. You, I or Mr. Buffett all have no clue what the market or a particular stock will do in the short or long-term.

This means you should favour stocks which are out of favour. They might be slow growers, stock which are having temporary troubles, or business pressured by negative sentiment.

It’s not just my opinion that these stocks are the best. Multiple studies back up the idea that value trumps glamour over the long run.

One such study was done by The Brandes Institute in 2012.  Their white paper, ‘Value vs. Glamour: A Global Phenomenon’ showed that, regardless of market cap, geography or industry, value wins.

The paper concluded by stating an observation Benjamin Graham, father of value investing, made more than 50 years ago.

If we assume that it is the habit of the market to overvalue common stocks which have been showing excellent growth or are glamourous for some other reason, it is logical to expect that it will undervalue — relatively, at least — companies that are out of favour because of unsatisfactory developments of a temporary nature.

This may be set down as a fundamental law of the stock market and it suggests an investment approach [value investing] that should prove both conservative and promising.

Regards,

Härje Ronngard,

Junior Analyst, Markets & Money

PS: Investing in equities isn’t just about picking the right stocks. It’s also about avoiding the wrong ones. Vern Gowdie, our award-winning financial advisor, believes there are five stocks you need to avoid.

In his report, ‘Sell These Five ‘Fatal’ Stocks Now’, Vern will show you the five biggest threats to your wealth, and how you can still prevent these mistakes now.

To get your free copy of Vern’s report, click here.

Härje Ronngard

Härje Ronngard

Harje Ronngard is a Junior Analyst at Markets and Money.

With an academic background in finance and investments, Harje knows how simple, yet difficult investing can be. He has worked with a range of assets classes, from futures to equities. But he’s found his niche in equity valuation.  

Leave a Reply

Be the First to Comment!

Notify of
avatar
wpDiscuz
Letters will be edited for clarity, punctuation, spelling and length. Abusive or off-topic comments will not be posted. We will not post all comments.
If you would prefer to email the editor, you can do so by sending an email to letters@marketsandmoney.com.au