So value investing, where to start. Well a long time ago, some very smart people developed value metrics (including Ben Graham, Warren Buffett's lecturer), one of which was the price earnings ratio.
I think it gained a lot of popularity due to it being easy to calculate and understand. At the same time it does give you some indication of whether something is cheap or expensive. There is loads of research on stock selection using the different metrics, and most of the time it shows choosing portfolios with low PE ratios will outperform ones with high. So then why is investing hard? Surely then we just buy the lowest PE stock and done!
Even Warren Buffett started his career (as a trader/investor) investing in "value" stocks. Companies with low PE's, low price-to-books etc. What is important to note though, is most of the time these were small caps that were thinly traded - you'll see why this is NB later.
So being on the academic side I obviously get exposed to a lot of the research, and when I discuss it with portfolio managers or analysts the response is always fairly similar, "Looking backwards always works, but try do it in real life". That said, they do normally start with or at least look at the current PE ratio.
I used to believe PE was a good indicator, until I understood it better. So the first flaw in PE, is the ratio is calculated using your past earnings, and price reflects market sentiment (how people feel about a share - future blog). So when using a PE ratio you are taking what happened and how people feel and trying to predict the future - that's why I shed a tear when people make a decision based solely on the PE ratio.
The market may be erratic, and at times wrong (mispriced), but sometimes it is reflecting what's actually happening. It is important to understand when a PE reflects what's happening or is a market mispricing, so you don't fall into the trap!
The value trap
Very smart people have learnt this lesson the hard way.
After articles one of my partners from Deloitte, George, called me up, and asked me to go for an interview with Fire, earth, water, wind(FEWW) asset management (name is made up as no need to bash reputations). So I read up about them, and went to go chat. First interview was fine, nice guys, smart etc. So I went back and really read into them, the funds, the performance the philosophy etc. Second interview, I asked them about their investment philosophy, stock selection and I couldn't believe what I heard. It was the value trap, my last question was "Will you be able to pay me?". I knew straight away they were going to struggle (and subsequently they did).
Myth: A low PE is always a value stock! A low PE MAY be an indication that stock is under priced.
I learnt this lesson not long before the interview. At the time (round 2010) I was fascinated by Anglo, BHP Billion, Sasol etc. They were all on very low PE's. Being still fairly new I wanted to know why, such highly traded, well known stocks could be priced so low. (At least I was skeptical and didn't just jump in.) So I chat to Kyle while running (we used to run on the Sea point promenade often and chat about shares, life and everything really), and I asked him his thoughts.
Lesson: Quite simply the market was looking at the future earnings. It is always important to say what's happening in the future, because you are buying future cash flows. This is where an industry and economics view is useful - i.e Doing your homework. If you looked at the world's supply of resources, there was a lot of supply coming into the picture at the same time, the world's economy was still uncertain, and add to this the demand was going down. So you would expect the resource prices to go down, and thus the profits of these companies would go down in the future. The market was aware and had taken that into account. So looks like textbook, value stock, but actually not.
Just a note: I think you would be lucky to find a cheap large cap stock, as there are lots of analysts covering it, research on it, and generally the market has a good understanding of its value. With smaller stocks, due to them being less traded and not as investable for unit trusts there is more chance of mispricing. (Although there is sometimes more risk - future blog).
Here a PE was reflecting what was happening, not a mispricing. FEWW was not the only asset manager to invest into these stocks, and a lot of funds performed badly from buying into these "waiting for the cycle to turn".
Myth: A high PE is an expensive stock!
If you go back to the blog "simplicity - investing is not rocket science", I talk about NEPI and Cartrack, both on high PE's yet both, in my view, seemingly undervalued (given the movements post acquisition - nepi gone up 300% and Cartrack 20-30%). This is an example where there is future earnings not shown in the current market price - Mispricing.
Some behavioural finance: Basically people don't like to sell at a loss! So they hold onto losers and don't see the trap, and just keep holding while it goes down. So this is why stop loses aren't a bad thing, because maybe when you are new, you might make mistakes. You might have heard people say, "in the long term it'll come back" or "I am a long term investor". So there is some merit to that, but don't use that as an excuse to justify a mistake.
Now the second lesson from the value trap. Is learning to eat your slice of humble pie.
The issue with getting value investing wrong, is when you think there is value and the price goes down, you now think there is more value, so you buy more, and more.
The best example of not eating the pie, I met with one of the heads of WEFF (interview) who had gone the whole hog on a few value stocks which I pointed that out, and asked him straight "Why don't you just sell them". He said to me, if we sell now we lock in the losses, and our unit holders can just withdraw and go to another fund. If we tell the unit holders we are in this for the long term and you don't want to lock in your loses by buying high and selling low, so hold, and in the long term will work out, as these are value stocks (they truly believed at the time they were good value). That fund under-performed for years and never sold out. It is very sad.
You might say, "hey but that sounds like you and ARB holdings (see Believe in yourself)". Now "believe in yourself" is premised on the idea you did your homework! However the primary difference is I did not buy ARB holdings, based on PE (or any specific value metric), I bought it based on it had lots of cash, and was making lots of cash and was growing - good business and I felt low risk.
Warren Buffett has an investment rule: "Don't lose your capital."
Remember the real value in investing is because you are compounding. So if you don't lose capital it keeps compounding. So to simplify long term wealth creation, it's not about hitting home run after home run, it's about NOT getting it wrong, because as long as you don't get it wrong you are compounding!