Important Investment Concepts, Part II
My last blog post, Important Investment Concepts, Part I, talks about an important investment concept that is intuitively obvious, that is to avoid large investment losses. This investment concept is most applicable to people who have accumulated a large nest egg and are nearing their planned retirement date. This blog post will discuss another important investment concept that is less intuitive and is applicable to investors of all ages. The second important investment concept is simply “Do the opposite of what everyone else does.”
There are two basic types of investing styles; “growth investing” and “value investing.” Growth investing is the practice of investing in high growth companies that are expected to rapidly increase their sales and profits in the near term and thus their share price. The high expectations of these type companies often cause them to have high Price/Earnings (P/E) ratios. Investing in companies such as Google and Apple are typical of these types of companies. Money can be made being a growth investor. However I, personally, do not practice this investing style for a couple reasons. First, it is a much more active way to invest as growth companies fortunes’ can change quickly, and, secondly, because of this active approach, growth investing is inherently more risky. For me growth investing requires too much monitoring of your investment portfolio. The purpose of this blog site is to communicate to the reader the ideas and concepts that have worked for me, so I will discuss the concept of value investing.
Value investing is the practice of investing in companies whose share price is below the company’s intrinsic value as indicated by one or more corporate financial measures (e.g., book value, P/E Ratio, etc.). Often these companies have some problem associated with them such as a reduced profit margin, a product recall, difficulty integrating a new acquisition, or some other perceived problem that puts downward pressure on the company’s share price. Sometimes a company or an industry can just be out of favor. However, these corporate problems are often short term in nature providing an opportunity for an investor to purchase a company’s stock at a temporarily reduced price.
Let me provide a quote by Warren Buffett: “The most common cause of low (stock) prices is pessimism – sometimes pervasive, sometimes specific to a company or industry. We (Berkshire Hathaway) want to do business in such an environment, not because we like pessimism but because we like the prices it produces.” To illustrate Buffet’s point I will tell you about the best gains I made in the stock market in the last 12 years.
In the years 1998 to 2000, the oil industry and the real estate industry were greatly out of favor. I understood why the oil industry was out of favor as the price of petroleum was hovering around $20 per barrel during this time frame. I am not sure why the real estate industry was out of favor, but I assume it was due to the savings & loan crisis in the early 1990s which was still fresh in many people’s minds. In any event, in the year 2000, no one was interested in real estate or oil industry stocks. Everyone was chasing the returns of the technology stocks; these were the growth stocks of that period. I saw petroleum and real estate companies as a real opportunity, but it required “doing the opposite of what everyone else was doing.” Even if the emerging market economies did not grow the way they ultimately did, I could not believe that the price of oil would stay at $20 per barrel. Additionally, the large integrated oil companies had single digit P/E ratios. Blue chip Real Estate Investment Trusts (REITs) were yielding between 10% and 12% (they normally yield around 5% to 6%). In 1999 and 2000 I scooped up oil company stocks and REITs in large numbers. Between 2000 and 2007 the oil industry stocks experienced share price increases of about 250% and the REIT indexes rose about 400%. These returns are in addition to the dividend income these companies provided during this period. Ultimately I sold most of my oil industry holdings and all my REIT holdings in 2006- 2007 when I saw the madness that was occurring in the real estate markets. Selling REITs in 2006 and 2007 was another example of “Doing the opposite of what everyone one else does” as every one was stilling buying real estate at this time. Buying what is out of favor and waiting for the market to recognize the value is the art of value investing.
But the thing I like the best about the value investing approach is it is a low risk approach to stock investing. As an example, what if my assessment in 1999 of the value of the companies in the oil and real estate industries had been wrong? What if these stocks were properly valued when I purchased them? That was entirely possible. But what is the worst that could have happened to my investments in 1999? These were all blue chip companies that were not going out of business. The worst that would have happened to me is I would have collected dividend income from my large integrated oil companies of between 3% and 4% per year with the dividends growing about 7% to 8% per year. My REIT holdings were yielding over 10% per year and the REIT income was growing at about 2% to 3% per year from 2000 to 2007. So if the stock prices did not change, I was still getting a return of between 3% and 10%. Compare that to the returns of the investing herd who were buying high growth stocks in the 1999 to 2000 time frame. Their return as measured by the QQQ index, which tracks the 100 largest stocks in the Nasdaq, dropped roughly in half from 1999 to 2007. In 1999 I felt the “Risk-Return” ratio was much better in the oil and real estate industries than the high growth technology stocks. As history showed it certainly paid to “do the opposite of what everyone else was doing.”
I will close this post with a quote from the greatest value investor of all times, Warren Buffett.
“Be fearful when others are greedy, and be greedy when others are fearful.”
In the volatile markets we have been experiencing lately this quote is important, now more than ever.
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