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When it comes to fundamental stock analysis (as opposed to technical analysis), the financial world essentially distinguishes between two schools of thought, namely growth and value.

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Very simply, growth stocks have high sales growth, high price/earnings ratios (or P/E ratios) and usually exciting stories (see e.g. Amazon or Tesla). Growth investors believe that the high valuation today is justified by further high sales or earnings growth in the future.

Value stocks, on the other hand, have low P/E ratios (price-to-book ratios or P/B ratios), are far from their past highs and the companies may be on the verge of bankruptcy.

Successful value investing is not as simple as we are led to believe

The problem here is that a deeper and more differentiated consideration of the value approach in particular does not usually take place in the financial media, e.g. in the usual stock market magazines, or in the lectures at the exhibitions or forums, etc. There, the focus is probably deliberately placed on the simple aspects of value investing. There, the focus is, probably deliberately, more on the simple aspects of the value investing approach.

Therefore, anyone who can use a screen and filter for the stocks with the lowest price-to-book ratios is already a value investor according to the logic of the financial industry.

Of course, there is also a rationale for this simple approach: various back tests have shown that with a portfolio of stocks with low P/B ratios we can basically beat the market by a few percentage points.

Unfortunately, this is not quite so simple in practice. For several reasons:

  • Few of us will actually have the discipline to build a broad portfolio of low P/B ratio stocks and reallocate it regularly
  • We will therefore tend to pick a few cheaply valued stocks by feel and hope that they will perform well. However, many companies with low P/E or P/B ratios are cheaply valued for a reason, so this approach is highly unlikely to produce the desired result.
  • The probability that we deviate from our approach after some time, e.g. because our stocks perform much worse than the overall market over a longer period of time, is quite high (and we start to doubt our approach)
  • The screen also does not give us any indication when (e.g. at which P/E) we should actually sell our shares again

The Wall St. Nerd idea: If you are going to invest, then do it smart!

So what is the overriding idea of Wall St. Nerd in this context?

To put it in Warren Buffett's words (translated as appropriate):

"It is better to buy a great company at fair value than an average company at a ridiculous price."

Warren Buffett

At Wall St. Nerd, we basically follow Warren Buffett's approach and focus on intrinsic value. We invest in businesses and business models. Based on this mindset, we buy shares in companies and not just stocks (mentally, this premise already makes a big difference).

We therefore do not use screens directly to select stocks, but at best to generate investment ideas. In addition to screens, we have many other possibilities to find investment ideas. Among other things, we can look at the portfolios of the top investors or special situations such as spin-offs, mergers, etc. We focus on the current share price.

Ideally, we only focus on the current share price once we know the intrinsic value of a company (to avoid our psychological biases as much as possible).

Once we have a company in our portfolio, we take a long-term perspective and generally ignore the day-to-day price fluctuations. We only sell when we no longer believe that the company's market position, management, etc. remain good.

As you can see, the value investor or value approach is quite different in some respects from what is typically understood by investing. For this reason, I would like to briefly go into some of the most important topics again. So, from my point of view, what characterises a Wall St. Nerd investor or a value investor?

By the way, I think the same logic applies to investing in real estate.

Intrinsic value and catalyst instead of current market price

First of all, there is intrinsic value. Intrinsic value is the essential basis for decision-making for a Wall St. Nerd investor or a value investor. A large part of our time in analysing an investment is spent on assessing the intrinsic value of the companies we are interested in. Among other things, this naturally includes analysing the business model, the competitive advantage, the quality of the management, etc.

In a second step, we then look at the share price and determine our margin of safety based on that. That means we calculate how far the share price is (hopefully) below the intrinsic value. If the margin of safety is high enough - Benjamin Graham had set himself a target of one third, i.e. about 33%, some value investors even have a target of 50% or more - then we consider an investment.

However, before we actually add the shares to the portfolio, we consider whether there might be a so-called catalyst. That could be an event within the company (e.g. an imminent change in the management team) or a change in the market environment that we expect could lead to an adjustment of the market price to the intrinsic value in the short to medium term.

It should be noted that such a catalyst does not necessarily always exist. It may also be that the market simply misjudges the intrinsic value over a longer period of time. In such a case, it may then take some time for our friend Mr. Market to realise his misjudgement on his own.

But as Warren Buffett said:

"Put together a portfolio of companies whose aggregate earnings march upward over the years, and so too will the portfolio's market value."

Warren Buffett

This means that eventually the price will follow the intrinsic value.

Low risk with high return

The conventional approach in the financial industry suggests that in order to achieve higher returns, we must also take higher risk. This may indeed be a way to achieve higher returns. But taking more risk usually means the possibility of greater losses.

Fortunately, we as Wall St. Nerd investors are not conventional investors who simply want to put their money into hot stocks and thus take unnecessarily high risks. Instead, we invest unconventionally and try to make smart entrepreneurial decisions - which is of course not particularly popular as a rule.

It means, for example, that at a time when everyone is looking for a home or property as an investment, we tend to avoid real estate as an asset class because of the high prices. The same applies to shares, which are in fashion now.

We minimise our investment risk by understanding the business models and competitive advantages of the companies we invest in. We do not believe in the risk approach taught at most business schools (i.e. efficient markets, diversification, etc.).

Focus instead of diversification

This also means that we generally do not spread our money around too much and do not hope that a few good investments will make up for the performance of the many bad ones. Instead, we invest most of our money in our best ideas and try not to include the bad ones in the portfolio in the first place. In total, we have maybe between 5 and 20 individual stocks in the portfolio.

While the conventional wisdom is that, it is riskier if we only have a few investments in the portfolio. However, what about when all of those investments are great companies? At Wall St. Nerd, we do not believe it makes sense to take parts of our money away from the best ideas and instead invest in second and third best ideas to reduce the price volatility we might experience.

After all, that is the conventional definition of risk: risky is something that fluctuates a lot in price, low-risk is something that fluctuates little in price (analogous to the discussion about the beta factor). Diversification in the classical sense leads to a decrease in price fluctuation. But does it also lead to an absolutely better return with the same (real) risk?

Ambitious return target

As unconventional investors, we try to beat the market over the long term. Although every Wall St. Nerd investor or value investor has a different target, it is typically around 5-10% above market. In addition, that is over various four- to five-year periods.

Without this return target, we could also invest in a passive index fund and sit back comfortably (but that is not what we are aiming for at Wall St. Nerd).

In absolute terms, this return target means a return of >15% to 20% per year or a doubling of our portfolio assets every 3 to 5 years (see also Mohnish Pabrai's portfolio strategy).

This makes a huge difference compared to investing in a passive index fund because of the compound interest effect.

To achieve this goal, we ignore the background noise of the financial world and instead turn to the corporate reports and financial statements of the companies.

Focus on psychological aspects: Independent thinking and mental strength

When we invest unconventionally, it can of course happen that we experience longer phases with our value investing approach, in which we could have achieved better returns with alternative strategies. This can sometimes be very frustrating for any value investor and make us doubt our strategy.

As value investors, however, we know that such phases can occur and always keep an eye on long-term success (because in the long term, the strategy works better than any other does).

And we know how important controlling our emotions is for the implementation and success of our strategy. Warren Buffett also learned this quite early on and never tires of pointing out the control of emotions as an important skill of a successful (value) investor:

"If you cannot control your emotions, you cannot control your money." Warren Buffett

"The greatest Enemies of the Equity investor are Expenses and Emotions." Warren Buffett

That is why we at Wall St. Nerd invest a lot of time in developing routines and processes that help us to control our emotions and our human instincts (behavioural biases), which can sometimes be a hindrance to successful investing.

In conclusion: How do we become good Wall St. Nerd investors or Value Investors?

I think some of us are programmed, so to speak, to invest (and act like entrepreneurs) unconventionally and on a Wall St. Nerd investor or value investor basis. For many of us, though, that can mean a lot of hard work.

However, in my view, we are well on our way to becoming an unconventional thinking value investor if we consistently follow and take to heart the following themes:

  • We learn everything we can about business models and how companies work.
  • We also internalise that the risk lies in the business or the investment and not in the strategy.
  • We look at the different investment and trading strategies. Only when we know the different options can we accept value investing as the best approach.
  • We develop an approach for estimating intrinsic value that works for us. There are many starting points for this here at Wall St. Nerd.
  • In addition, we internalise that the price usually follows the value, i.e. that the share price will reach the intrinsic value at some point and say goodbye to daily monitoring of the share price development.

I do not think we have to be unconventional to achieve our goals. However, we have to pursue (investment) strategies or define investment processes that bring us closer to our goal systematically and that also take the psychological aspect into account.

About Alexander Kelm

Alexander Kelm is a passionate value investor and runs the website Wall St. Nerd. Here, the passionate value investor writes in-depth articles on the topic of Value Investing. Value Investing involves analyzing a company's fundamentals and can be characterized by an intense focus on a stock's price, its intrinsic value and the relationship between the two.

Alexander Kelm offers online courses on stock investing.

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