Warren Buffett’s investing mentor shares two investing strategies to avoid and three that actually work.
Whenever the stock market takes a tumble or volatility increases, I always see a bump in visitor traffic to the blog. Investors are content with market returns when stock prices rise year over year but rush to stock picking and investing strategies when the markets weaken.
Unfortunately, many of the most popular investing strategies end up losing more money than if the investor had just stuck with a buy-and-hold strategy.
That’s because most stock-picking strategies are so common that investors pile in and bid up prices or the strategy is based on no real rational analysis.
An excellent lesson in this is found in chapter seven of Benjamin Graham’s The Intelligent Investor. I’ve been reviewing each chapter of the most widely-read book on investing and the chapter on investing strategies for the ‘enterprising’ investor is my favorite so far.
In fact, one of my favorite stock funds tracks investments by Warren Buffett along the strategies developed in the book.
Can Investing Strategies ‘Beat The Market’?
Graham begins the chapter by disproving two of the most popular investing strategies that consistently lose money.
The concept of market timing on price-earnings signals is likely one of the most popular stock-picking strategies among investors. It seems like common sense, avoid stocks when they are ‘expensive’ and you’ll never pay too much.
The problem is that P/E ratios for the market have been rising for decades and provide a poor signal of when to get in or out of the market. If you had stayed out of stocks when the market P/E was above 20-times, you would have spent most of the last two decades out of the market according to data by Robert Shiller.
Investing in the stocks of fast-growing companies is also a popular strategy. Investors drool over the 800% return in shares of Tesla Motors (TSLA) over the two years to September 2014. They pile into stocks of companies with surging revenues, willing to pay any price for the shares.
It’s not to say that growth investing can’t pay off but the problem is that the usual suspects for growth are bid up so high that prices already reflect double-digit future earnings growth. These hot stocks rarely live up to the market’s hype.
Before detailing three investing strategies that have actually provided positive returns, he outlines two criteria for any strategy.
- It must be based on fundamental analysis or some rational reasoning for success
- It must not be followed by so many investors that the market has already pushed up prices
Three Investing Strategies That Actually Work
While the first half of the chapter will help you avoid losing money, the back half details three investing strategies that have produced higher returns both in Graham’s time and more recently.
#1. Contrarian Investing In Large Companies
Investors are an optimistic bunch and love to send prices higher. It takes a real hit to sentiment to send a company lower but can be a buying opportunity when it happens. Graham suggests watching for large companies that have come under fire and seen their shares plummet. The idea is that companies with billions on the balance sheet have the financial power to survive and reinvent themselves, bringing investors and the share price back.
As with all three strategies, contrarian investing is going to involve some work to do it correctly. You need to research the cause of the drop in shares and decide whether it’s a temporary setback or something worse. Warren Buffett has played the contrarian for years in shares of International Business Machines (IBM) but looks to have the last laugh on a 15% gain in the shares so far this year.
#2. Bargain Stocks And M&A Investing
Graham is credited as defining the modern investment analyst with his teachings on fundamental analysis. He suggests that investors can earn higher returns through investing in stocks that trade significantly under their true value.
This one is harder to define than the other two strategies and really requires some work, sifting through annual reports and developing your own measure of value. Graham suggests looking at companies in which acquisition activity has been increasing and evaluating companies that are trading below the value they might be worth to buyers.
#3. Investing In Special Situations
Graham’s final investing strategy includes ideas from the prior two strategies. The idea is to watch for stocks trading cheaply on special situations including potential acquisition targets, monopoly breakups, companies hit with lawsuits and buying the bonds of restructuring companies.
Of the three investing strategies, playing the contrarian is probably the easiest. It involves following fewer companies, those with a market cap above $10 billion or so, and doesn’t require some event like an acquisition offer to turn the shares around. You will need to be patient though and give your investment time to play out. Buffett has fought off skeptics since 2011 on his IBM bet.
You don’t have to ‘beat the market’ to meet your investing goals. Investing regularly in a diversified portfolio is just as important as finding investing strategies that work. If you are looking for a little higher return, make sure you stick with Graham’s criteria for successful stock-picking.
Author Bio: Joseph Hogue, CFA is an investment analyst and runs six blogs including PeerFinance101 and MyStockMarketBasics. He holds the Chartered Financial Analyst (CFA) designation and lives in Medellin, Colombia with his wife and son.
[Photo Credit: Devanath]