Saturday, August 06, 2022

Why you will fail at Value Investing - part 3


Having established that the company has a high business and management quality. The final step is to determine whether the price is cheap enough to justify a market entry. 

It is this process that I find the hardest to execute.

The author does initially seem to employ a simple metric to determine whether the entry is worthwhile. He starts with the earnings yield numbers which is 1 divided by the PE ratio of the company.

But it is the next step that resembles sorcery more than science. 

As tech companies invest in a lot of R&D, it is entirely possible that earnings after deduction for R&D will be low, so the analyst would have to moderate the earning yields. So the company may have an earnings yield of just 2%, but a smaller company in the same space may have less R&D and were able to conduct their business comfortably at an earnings yield of 10%, the earning yield, now relabelled as earnings power may be adjusted closer to 10% to reflect the market reality. 

The details do go a little deeper when you read the book, but I think it would be very hard for actual retail investors to be able to do this confidently without, once again, tricking themselves into falling in love with the company.  

The idea is that if you can find an earnings power of 5%, you can comfortably add the stock to your portfolio.

Ok, so I'm done with my review, how can we treat the book as a whole?

I'm actually not militantly against this latest version of value investing. While there is a subjective component in each step of the analysis, an investor who applies this consistently as a whole against one specific industry may be able to find some success using this framework. But the question for folks like me is whether superior returns when it does occur, come with higher volatility. Furthermore, can these superior strategies beat momentum-based trends following stock picks in an economic expansion which is where tech-stock picking is at its strongest?

Finally, I'd like to say that I won't review a book if I don't really see some value in it. But perhaps a better value investing toolbox can be a wider literature review of books in this space, which is exactly what you will find on my blog over the next few weeks.   



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