I had it backwards my whole career…
For most of my time on Wall Street, I was an old-school value investor. That meant I dug through the “bargain bin” looking for stocks that traded at low multiples of their earnings or other key metrics.
The problem was, the cheap stocks were usually cheap for a reason… because the underlying businesses were crummy. So the seemingly cheap stocks turned out to be value traps – they just went down and down as the businesses declined.
If you’re a frequent DailyWealth reader, you know where this is going. As my friend Steve mentioned recently, I’ve changed – and improved – my approach to investing and how I pick stocks.
Today, I’ll tell you why…
You see, falling for value traps is just one of the four mistakes that tend to plague classic value investors. The other three are:
- Failing to buy high-quality businesses because they didn’t look cheap at the time.
- Selling great businesses too soon because their stock prices soared “too high.”
- Failing to understand and appreciate powerful new technologies and trends.
I’ll confess – despite all of my successes during my 20 years in the market, I’ve made every one of these errors.
I want to emphasize, however, that the lesson here is not to just do the opposite and buy the stocks of great growth companies irrespective of valuation. Growth investors frequently make four mistakes that are, in many ways, reflections of the ones value investors make:
- They overestimate future growth, forgetting the powerful force of reversion to the mean. They miss the impact of changing technology, new competitors, size acting as an anchor to growth, etc. Trees don’t grow to the sky.
- They pay too high a price for a stock, such that even if the business performs well, the stock doesn’t.
- They fall in love with great companies and fail to sell when they should.
- They get sucked into “story stocks” – businesses full of excitement and promise where expectations grow way out of line with the fundamentals.
The truth is that both quality and price matter… But they’re not equally weighted. I estimate that 75% of what determines a stock’s performance over time is how the company performs, and only 25% of it is the valuation at the time of purchase.
Unfortunately, for my entire career I had this backwards: I looked among cheap stocks and tried to find good businesses, when I should have looked among good businesses to find reasonably priced stocks.
That’s why I changed my approach.
Today, rather than a classic value investor, I call myself a “make money” investor – meaning that I try to combine the best of value and growth investing.
I believe it’s a great way to avoid the common pitfalls of both sides, while investing in better businesses right from the start.
So stop digging in the bargain bin. Instead, look for high-quality companies and wait until you can buy their stocks at a reasonable price. If you are smart, courageous, and patient, you will crush the market.
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Source: Daily Wealth