Friday, October 8, 2010

Do we have an end to "value investing"?

As someone who likes to study stocks and investments, I have always considered myself a "value investor."

Probably from reading Warren Buffett's books in college and being the nerdy type who actually enjoy's reading The Valueline Investment Survey, it always made sense to me to invest in companies with growth in earnings or same store sales with good fundamentals.

And, it's difficult to argue with this logic. I mean, why wouldn't solid companies that make money be good investments?

If you look at the recent history of the stock market (over the last 15 years or so) you start to see a change in the way stocks are traded that seems to erode this value logic. Although there has been general growth in the number of dollars invested overall, the amount in straight equities has been relatively stable.

So where is this extra investment?


There has been an explosion in the both the number of option contracts -- everything from the typical stock and futures, but also on positions like the index markers. So what does this have to do with "value investing"?

Well options of course give you the right but not the obligation to purchase stock at a set price within a given time. They are extremely sensitive to both the underlying stock (or index or future) price and also the time value (that is, the time until expiration of the contract).

By their very nature they are a short term investment. I know, I know, there are LEAPs and other issues where this isn't true, but far and away the majority of option contracts terminate in the short run.

To me at least, this has given the stock market a different flavor and bias in investing your hard earned cash. There is now a tremendous number of dollars being invested in short term price movements -- and therefore away from the long term positions of holding the stock.

Now, technically, if someone was going to purchase an option wouldn't there have to be a willing seller that "owned" the stock?

Well not so fast. Now comes leverage. Most of the time that option contract you purchase is from someone who doesn't own the stock -- instead using their margin account to promise you they will deliver if if you decide to exercise.

Options aren't the only reason I think value investing has tamed a bit. The other is "robo-trading". Or as one of my friends put it: "to be robbed trading."

You only have to look at the recent report concerning the "Flash Crash" that the stock market had in May and you can see the effect that one broker and one trade had in drying up the liquidity in multiple markets with a computer based trade algorithm. The result was millions of dollars of loss in a single afternoon.

These computer exercised trades open and close positions in milliseconds -- a far cry from working out your trade at night with a pencil and a copy of Valueline on end of day trading numbers.

So for me, both options and robots have changed the way I see investing.

No, I haven't cancelled Valueline (although I read it on the computer now), but I have spent time educating myself on option contracts and how they can be used to my advantage. And I have changed brokers (after a decade) to one with a more sophisticated trade screen with Level II quotes (its free now) so I get to see these short term price movements.

I've also come to believe that my previous thoughts that technical analysis was voodoo were wrong.

Unfortunately when all investors are at least to some extent lemmings, and more and more institutional investing is short term and therefore based on technical indicators, we small timers have to be able to read a chart too.

If for no other reason than to determine market entry and exit timing.

I still don't think pure technical indicators are a reason to buy a stock (I don't care how much price change there is in an insolvent company), but I think they do play a role in the overall gain or loss of an investment.

So for me, pure "value investing" is over. I think I've come to terms that there has to be a good blend between both long and short term investments.

I know that Charlie Munger and the folks at Berkshire Hathaway may disagree with me (and they are a lot smarter), but in this economy I think expecting to hold an investment for three to five years has to carry some inherent risk that the companies market share will change or there will be a decline in the fundamentals.

So the question now is, do you lower or exaggerate the risk by blending in some short term positions?

I don't know the answer. Ask me in again in 5 years.

- Posted using BlogPress from my iPad

Location:Caruth Haven Ln,Dallas,United States

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