Value Investing

“You get what you pay for” is as true in the stock market as it is when buying a new pair of shoes. But how do you know what a company is actually “worth”? Appearances can be deceiving.

Consider a company that is growing rapidly and earning high returns on incremental capital (and thus is priced quite high) compared to a business that is highly capital-intensive with little growth. The latter may be “cheaper” and the “best value” as measured by conventional price/earnings and price/book value ratios, but the former—the “more expensive” stock—may in fact be far better value in the long run, based on its potential for growth, returns on incremental capital invested, and the ability to generate free cash and then deploy it wisely. We will almost always choose to buy the former, even if it costs more at the time.

Asset mix has a lot to do with an individual’s financial situation, age, and personal risk tolerance. One of the most common question clients ask us is how much they should invest in equities compared to how much they should invest in fixed income.

The answer is, frankly, it depends on you. When you compare 10-year bond yields with earnings yields, stocks are often more attractive given that their earnings are growing and bond yields are relatively static. However, it is critical that your account reflect your tolerance for risk and your income requirements. A portfolio that is fully invested in stocks is not for everyone: even though it may have a greater likelihood of outperforming bonds over the long term, if it is going to keep you awake at night, that’s no good.

Including bonds with stocks in a balanced portfolio reduces overall portfolio volatility, although the trade-off is it will probably result in lower returns compared with an all-equity portfolio. But if it helps you to sleep better at night…well, a good night’s sleep is truly priceless, isn’t it?