Newbie wanting to risk 10% using value investing

[Comar]

I have been investing about half my salary in funds and so far things are going well. I'm thinking long term, 10+ years, building wealth and reaching for FI.

It's fun and empowering. Lately though I've been thinking about putting maybe 10% my money in stocks. Since the economic crash people here in my country can only buy domestic stocks. I've been reading about value investing and want to try it out just for the fun of it. There is an index of 8 companies and I was thinking about buying one that has recently dropped 10%. So I'm thinking that's undervalued. My strategy is to buy and hold until it has corrected the 10% drop. Then sell and make a 10% profit if this turns out like I hope it will. I don't know how long it might take and don't care as I see this as an entertaining lesson.

I still consider myself a newbie. Do you think my thinking is dumb or naive? Given that my suspicion that the company is undervalued is correct, do you think the strategy makes sense?

Your five cents would be very welcome.

[Ursus Major]

Hi Comar,

I think that it is a great idea that you're asking, whether this makes sense. That alone already puts you ahead of 99% of people, who have similar ideas. Having said that I do think that your idea is "problematic" in several aspects. I'm just throwing out some thoughts for you:

• Yes, doing active investing is fun and empowering. It's also immensely frustrating, irritating and disheartening. So it can be both. I'm not a proponent of the strong efficient market hypothesis and I don't think that there is something wrong with using a small percentage of your portfolio to so some active investing. But do keep it small. Probably 5% is better to start with than 10%, but even 10% is okay.
  
• Unfortunately you do not mention which country you are coming from, but an index with only eight companies is not a viable index in my book. I looked into your other posts and it seems that you are from Iceland and are talking about the NASDAX OMX Iceland (https://en.wikipedia.org/wiki/Iceland_Stock_Exchange). Is that correct?  If so, think twice, because according to Wikipedia

  Because of the small size of the Icelandic economy and the low cost of public listing, many of the companies traded on the ICEX are relatively small and are relatively illiquid.

  I don't know, what companies are in the index, but if it's highly dependent on natural resources, then that causes trouble any time the price of natural resources go down.
  Perhaps waiting until you're able to invest in international stocks is the more prudent choice of action.
  
• You use the term "value investing", but it is not clear to me, what you mean by that. For some folks a "value stock" is simply one with a low P/E ratio. Other define value investing as determining the intrinsic value of a company and then buying stocks with a margin of safety. That is the classic Graham/Buffett approach. Of course that means that you need to be able to actually determine the intrinsic value of a company in a reasonably narrow range. When you do that kind of assessment with the DCF method, you will find out that just the tiniest changes in your assumptions, can change the intrinsic value by 10% or 20%.
  
• Your strategy sounds more like a "buy on the dip" strategy, because it is entirely price-driven, not driven by prices vs. intrinsic value. That may work, however who says that the index can't fall another 10%. And then another... So if things go south,  you might just bail at the most inopportune moments.
  
• When you use any kind "active" strategy, you are going against the market. But that means you need to have the conviction that you are right and the market is wrong,  you need to have solid facts to back up that conviction and you need to know the limits of that conviction (that is at what point do I throw the towel). And that shouldn't be driven by market price (I sell, if it goes down 50%), but by business fundamentals (I sell, because the business is doing much worse than I anticipated and will do so for the foreseeable future). For that you'll need a good emotional constitution. Otherwise you end up like the investor in this chart
  

So that's all I can think of at the moment. But feel free to ask more questions or voice your concerns or disagreements. Just keep in mind that my thoughts are worth what you paid for them, which is a lot less than five cents. ;)

[Derrian]

A 10% drop in value does not necessarily equate to being undervalued by 10%. Buying something after a price drop also does not equate to value investing. It seems like what you are trying to do is time the market (after a 10% drop) with a very small (i.e. not diverse)  index fund and hoping it goes back up.

[Interest Compound]

Nope. I wouldn't do it even with 10% of my portfolio. It sets a bad precedent. The words "fun" and "entertainment" have no place in your portfolio. If you want fun, rent a movie or something. Leave your portfolio out of it.

[Rubic]

... I see this as an entertaining lesson.

I still consider myself a newbie. Do you think my thinking is dumb or naive? Given that my suspicion that the company is undervalued is correct, do you think the strategy makes sense?

I've taken the liberty to bold the keywords in your post.

A hunch or a suspicion that a company is undervalued is not an investment strategy, much less a method of value investing.  You are deceiving yourself if you think that only investing 10% of your funds in this manner is sensible.  And your tactic of selling on an arbitrary 10% upside makes no sense.  A deep value investor is looking for investments with a 25%+ margin of safety and has a range of values where they expect to see significant upside.

[faramund]

I believe that I've slightly beat the market by using buy-and-hold value investing approaches, but what you're talking about isn't anything I'd recognize as value investing, maybe its some sort of contrarian technical trading.

Be that as it may, I think using 10% of your funds to try something else, isn't bad, but on average, it probably won't work, so.

Make sure you only use 10% of what you put it, not 10% of your current value, consider the following.

Get $1000, put $100 in experiments, $900 in index. One year later let's say the experiments grow 1%, and your index 10%, so.

Experiments $101, $990 index, total 1091. At this point, you really shouldn't say, oh, my experiments are less than 10%, I should push another $8 from the index to the experiments. If you do this, on average, you will be shifting money from whatever the best approach to the worst one, and that WILL have a very strong effect on your returns.

Its also a mindset, its easy for people, if their experiments go badly, say they fall by 50%, to take some of the money from the index to 'make up' for that fall, and then think all is fine.

Another point of keeping a fixed ratio, is that in the future, 2, 3 or 4 years out. You can look at your two approaches, if your experiment has grown by 100%, and your index by 50%, you could shift some more money to your experiment, but if its the opposite, you should bite the bullet, and reduce your experiment.

[Gonzo]

The stock market can make anyone look foolish.  Sometimes, stock prices can remain low far longer than you think.  It's also possible that you incorrectly assess their fair value, and in that case, you overpay even at a lower price.  You can spend all your time researching and still be far wrong.  There is a road of bones leading away from the stock market, all from smart people who thought they had special insight. 

That said, I still take chances.  It's your money, so if you want to play, play.  Just don't let it get out of hand, by doubling, tripling, quadrupling down when you're wrong and so forth.  That's how you lose big.  You also need the courage to sell for a loss when you discover you were wrong, and sometimes that is the hardest thing to do.   

[Woody Viet]

This strikes me more as speculation than investment. You'll be competing with 90% of Wall Street so unless you think you have an edge I wouldn't try it. Why not put say 1% of your portfolio into it and see how it goes? Or better yet run a simulated portfolio for a few years?

[yoda34]

I would not do this. What you are describing is in no way value investing. The price movements of any asset across any given set of time tell you nothing about it's value. You have to add outside context to make any kind of informed choice. As a example, when Netflix fell 10% off it's high, it was still overvalued.

Value investing is about understanding the value of the asset and buying the asset at a price lower than that. Graham specifically advocated buying NCAV and NNWC stocks (stocks trading below their net current asset value or even more conservatively below their net working capital.)

As an example if you have a company that has 40M in cash, no inventory, no accounts receivables, and 10M in liabilities but is trading at price that puts the market cap at 5M then this companies price would be well below the Net Working Capital Value. You could theoretically buy the entire company for 5M and receive 30M in cash immediately. These were pretty common situations in Ben Grahams days and Buffet's early days not so much anymore.

Now folks have moved on to relative value estimation and "moats' and other things, but the intent is the same.

What you are suggesting is basically "well it went down so it must come back up at some point." It may indeed come back up but don't fool yourself into thinking it would be anything other than chance. 

[YoungInvestor]

I like using a portion of my portfolio to do value investing based on my own research, and have done quite well, but what you are suggesting is not value investing, it's just "well, that's down by 10%, it's bound to come back up".

[Comar]

I feel very grateful for all the wise comments, especially the detailed reply by Ursus Major. I believe I wrote this post while caught up in my emotions, feeling all Klingon, and after sobering up a bit after reading your comments I feel I should take a more Vulkan approach. I'm going to keep buying funds and will move it into Vanguard global, s&p 500 and vanguard europe when it will become available again in my country.

I got fascinated by the idea of value investing after reading a bit about it in a book about Warren Buffet. I did a little research about a few domestic companies and felt (I admit it was just a feeling or you may call it suspicion) one of them was undervalued. This feeling was further entertained when I read in a local business paper that some "experts" belived this company is actually undervalued by 21%. They actually used the term undervalued and I had just read about value investing. Surely this was a sign of my excellent reasoning and logic.

But as I said I have decided against buying this stock and will stick with my old strategy. I don' t really know anything about value investing. Thanks for talking sense into me.

I need

[faramund]

I feel very grateful for all the wise comments, especially the detailed reply by Ursus Major. I believe I wrote this post while caught up in my emotions, feeling all Klingon, and after sobering up a bit after reading your comments I feel I should take a more Vulkan approach. I'm going to keep buying funds and will move it into Vanguard global, s&p 500 and vanguard europe when it will become available again in my country.

I got fascinated by the idea of value investing after reading a bit about it in a book about Warren Buffet. I did a little research about a few domestic companies and felt (I admit it was just a feeling or you may call it suspicion) one of them was undervalued. This feeling was further entertained when I read in a local business paper that some "experts" belived this company is actually undervalued by 21%. They actually used the term undervalued and I had just read about value investing. Surely this was a sign of my excellent reasoning and logic.

But as I said I have decided against buying this stock and will stick with my old strategy. I don' t really know anything about value investing. Thanks for talking sense into me.

I need

If you find investing interesting, you should enjoy reading more. But if you don't, going with indexes is fine.

My favourite book about what sort of things to invest into, is:
What works on Wall Street, O'Shaughnessy: he divides stocks into deciles of all sorts of things, say from highest to lowest PE, and then he calculates what has worked best over the last 40/100 years. My only problem with it, is that his calculations are all based on rebalancing each year - which would kill me with capital gains tax - but his insights like, stocks which pay higher dividends, return more total value each year, than those with lower - guide me in which stocks I buy.

Another good one is
Stocks for the Long Run by Siegel which is just a good-all-round stock investing book.

[Ursus Major]

If you'd like to read more about value investing, I suggest the writings of Aswath Damodaran, who teaches corporate finance and valuation at the Stern School of Business at New York University: http://pages.stern.nyu.edu/~adamodar/

He even posts (at least some of) his books online, so there is a ton of valuable material available for free. It's pretty dense reading material though...