Wednesday, February 28, 2007

Successful Investing 101 - Value and Momentum Systems

During my investing lifetime, I have practiced two types of investing strategies - Value and Momentum. I would like to share my definitions of both and my experiences with each system

Value Investing

The classic value investing mantras are: "Buy low and sell high," and "Pay 50 cents for something worth a dollar." Warren Buffet, Benjamin Graham, Peter Lynch and John Neff are a few well-known investors that subscribe to this philosophy.

You may be asking, "Who in their right mind would sell something worth a dollar for $0.50?" The answer is they wouldn't, if they knew how to get it's full value. Here's an analogous situation. You are a collector of 1950's widgets. You are visiting your aunt and decide to attend a local estate auction. As it turns out there are two 1950's widgets being auctioned. However, neither the auctioneer nor the bidders know much about widgets, or 1950's widgets for that matter. As a result, you acquire the widgets for 1/3 to 1/2 of "market value."

Similar situations exist in the stock market. Except, it is never quite as obvious as the above examples. As it turned out, virtually the entire stock market in 1982 was a value play. However, very few people recognized that since interest rates were around 12-14% and the stock market had languished for about a decade.

Momentum Investing

The mantra of the momentum investor is "Buy high and sell higher." William O'Neill, founder of the Investor's Business Daily, is a major advocate of this approach. The system is built on the belief that a rising stock will continue to rise, for the reasons that have already caused it's price to increase. It could be due to fundamental, technical or other reasons.

The "risk" with this system is that one is often paying a premium for a stock. As we have seen with the recent real estate bubble, what goes up eventually will stop going up. Obviously the key to this system is to get in before the peak happens:-)

This week's precipitous drop in the indexes leads one to ask if the market is starting to move the value zone. I don't know. Personally, I have not been able to consistently make good returns on value investing. More often than not, my "value" stocks tend to go lower, making them not such a good value:-( A few times, I have made good picks and been rewarded. For example, I bought Dell in November of 1998 after it had declined and it increase six-fold in the next 18 months. However, I attributed that one more to luck than skill :-) At this point, I am going to wait for a clear bottom before buying.

In addition, it is often a difficult analysis for me on whether a stock is a value stock or on it's way to becoming a valueless stock. This issue happened to me with Southmark, and Richton International, now both bankrupt. The critical question today is whether Microsoft, Dell and Ford are value stocks or destined to eventually become extinct. Of course, I don't know the answer:-)

Over the past two years, I have had pretty good results with my variant of the Unemotional Growth System from the book, the Unemotional Investor by Robert Sheard. It is a momentum system that uses timely stocks from the Value Line Investment Survey and the Investor's Business Daily EPS ranking to select stocks to buy and to determine which stocks to sell. For my most recent picks, see Q1 2007 Stock Purchases.

Disclosure: I sold my positions in Avnet yesterday for about a 35% gain, even though there was no sell signal. I continue to hold Coach, Biogen, and Genlyte.

Update 3/4/07: I sold Coach, Biogen and Genlyte on 3/2/07. For more details, see Q1 2007 Stock Purchases Update - Closed All Positions.

For more on The Practice of Personal Finance, check back every Wednesday for a new segment.

This is not financial advice. Please consult a professional advisor.

Copyright © 2007 Achievement Catalyst, LLC

1 comment:

traineeinvestor said...

Great post.

Although I personally am a value investor, I have some serious and not so serious doubts about whether either approach is "best". As examples:

1. to a certain extent, value investing involves expoiting differences of opinon about future earnings (and other factors that affect valuations). Why should I as a part time investor with limited resources have any confidence that my opinions are any better than all the professionals who run actively managed funds that, as a group, underperform the market?

2. momentum investing assumes (i) that the recent past will repeat itself and (ii) that there will be someone else out there who will be prepared to pay more than I did. Assumption (i) is difficult to reconcile with portfolio rebalancing and assumption (ii) sounds a lot like the greater fool theory.