Investment decisions should be valuation-based because the price you pay is the biggest determinant of your long term return on investment. All investment decisions are based on probability because no one has the ability to accurately forecast the future. This makes optimizing your positive probabilities a key to successful investing.
In the AAAMP Value Blog post, Investment Probability Made Practical we discuss how understanding probability will help an investor avoid short term prognosticators and concentrate on a long term investment plan.
Although short term movements in the stock market are random, the positive bias of the stock market makes long term investing much more certain. The positive bias comes from the fact that companies create and build wealth through productive enterprises. Additional certainty can be achieved through valuation-based asset allocation.
Your best means of increasing the probability of higher than average returns is to make valuation-based investment decisions. Valuation-based investment decisions can be implemented in your asset allocation and individual investments.
How Market Valuations Affect Investment Decisions
Recipient of the 2013 Nobel Prize in Economics, Robert Shiller was a pioneer in market valuation-based studies. Shiller developed the popular Shiller PE10 which smoothed inflation adjusted PE ratios over 10 years. The evidence has validated his prognosis that using market valuation-based metrics in investment decisions increased the probability of outperforming passive or strategic asset allocation strategies.
Evidence supports investing in equities, when the ratio is low, has lowered investment risk and provided higher long term rates of return than passive strategies. The inverse is also true. Investing in equities when the ratio is high has increased investment risk and provided lower long term rates of return than passive strategies.
Where is the Shiller PE10 today? Current Shiller PE10 Valuation
What does this mean? The long term historical mean of 16.5 would imply a annual real return on equities of 6.5% over the next 20 years. The higher the Shiller PE10 the greater the risk, and the lower the implied return in the long run. A low Shiller PE10 equates to lower risk and a higher implied rate of return.
Additional recent studies have validated valuation-based asset allocation in investment decisions. For those interested in further research, here are the articles published in the Journal of Financial Planning:
Withdrawal Rates, Savings Rates, and Valuation-Based Asset Allocation by Wade D. Pfau, Ph.d., CFA
Improving Risk-Adjusted Returns Using Market-Valuation-Based Tactical Asset Allocation Strategies – by Kenneth R. Solow, CFP®, CLU, ChFC; Michael E. Kitces, CFP®, CLU, ChFC, RHU, REBC; and Sauro Locatelli
How Individual Valuation Affects Investment Decisions
Valuation is also a crucial concept when making individual investment decisions. It’s not enough to research and find quality companies. You can buy the stocks of great companies who grow earnings and dividends but still lose money because of the price you paid.
Cisco Systems (CSCO) has steadily grown its earnings from $0.37 cents in 2000 to $1.87 in 2013. Yet the stock price fell from $77 to $23 over the period.
Microsoft (MSFT) peaked around $60 in 2000 and fell to under $15 in 2009. This was despite the fact the company had grown earnings from $0.89 to $1.62 during the period. That is a 75% drop in the stock price while earnings increased 82%!
There are many examples such as these. Never mind the many poor quality stocks that were purchased in 2000 that declined to zero. You get the point. Even if you buy a quality company that increases earnings and dividends for many years; you can lose money if you paid too much for the stock.
This is why value investors look for a margin of safety. If you pay a low enough price for any investment, it reduces the long term risk of losing your investment. There are value investors who scour the investment landscape for troubled, even bankrupt companies. If you pay a low enough price you can still make money as long as the price does not go to zero.
My favorite initial stock screen is Return on Enterprise Value (ROEV) . This one metric is a great starting point for identifying stocks that are reasonably priced.
Making Investment Decisions
If I had to give value investing advice in just two words it would be: price matters! Whether it’s the valuation of an entire asset class or the price of an individual investment, it’s the price that will be the biggest determinant of your returns.
The best value investors are those who are able to obtain favorable probabilities by making valuation-based investment decisions.
Do you have the discipline to make high probability investment decisions?