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the psychology of successful trading

Value Investment: Buy Bank Stocks

Introduction

I recently discussed (in Investment Styles) the two major different styles of investing: value and momentum. One difficulty with following a value approach is the difficulty in measuring value. That’s because many assets these days are not very tangible. I will suggest here that, counter-intuitively, buying bank stocks is the solution to this problem.

Value Investing: What is it?

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The value approach to investing is simple to understand, though perhaps a little harder to implement.  The basic idea is that you buy things when they are cheap.  Finding cheap assets would classically rely on looking at concepts like “book value.” That is just the accounting value of everything owned by the firm in which you are thinking of investing.

In previous decades, book value would have been simple to calculate: you could just look at the published accounts. You would check how much the accountants said each asset was worth.  A company making cars, say, would own a lot of items like factories, car parts, machinery and land.  You could look at all of those items that you could walk up to and touch, and add up all the values. And that’s it: you have calculated book value.  

If you can buy the stock for less than book value per stock, you have made a good investment.  If the company sold all of its assets, and turned that book value into actual cash, each shareholder would get more than book value.  That’s why value investing is a good idea, and why you should try to buy stocks at less than book value.

It is true that value investment has not performed well in the last decade. We need to see if this changes. I would prefer to fail buying cheap assets than buying expensive ones.

Why Using Book Value is More Difficult These Days

This simple approach is more difficult in modern times, because IP — Intellectual Property — is much more important than it used to be.  IP is anything the company owns which is valuable but that you can’t touch.  It could be a suite of software, the value of a brand, or

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simply the know-how involved in producing the products or services that the company produces.  To illustrate the scale of this IP problem for value investors, consider the following estimate.  Ocean Tomo, an investment bank, reckoned that the proportion of the value of S&P500 companies which was tied up in IP increased from 17% in 1975 to a huge 84% in 2015.  So it is clear that there is a very serious problem in adopting a value investment approach these days, and that’s unfortunate because in my opinion, it is the only approach that works.

Value Investment: What Should Investors Do?

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If you look at the balance sheet for Deutsche Bank, for example, you will see a very large number of items.  They will all have market values though.  That will be true of shares, bonds, interest rate swaps, credit default swaps, loans to corporates, futures and options, office buildings, warrants, cash in various currencies and any of the other myriad financial assets.  There will also be a certain amount of brand value but I think that will be fairly low in the mix.  So basically everything owned by Deutsche Bank could be turned into cash, and a known amount of cash, quite quickly.

See: https://www.db.com/company/index.htm

Value Investment: Conclusion

Banks typically traded at 2.0x book value before the crisis.  The rule of thumb for value investors in the sector was “buy at 1.0x book value, sell at 2.0.”  Something like this is still true: you can buy Deutsche Bank at 0.3x book value and I think you should.  That’s the right approach for value investors today.

See Also:

Investment Styles

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the psychology of successful trading

Investment Styles: Value Investment

What are Investment Styles?

There are two major types of investment styles which take completely different approaches.  They are value investing and momentum investing.  The former, also known as contrarianism, seeks to find cheap assets to buy.  It is called contrarianism because often it involves looking for assets which are cheap because no one likes them.  Momentum investing is simpler.  This simply observes that often, assets that have been performing well continue to do so.  So investors adopting this style just look for assets which have gone up and hope that they will continue to do so.

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Investment Styles: Value

I think the best investment style is value investing.  One reason for this is because the problem with momentum investing is that assets which have done well continue to so until they don’t.  There is no way to tell when something which has gone up will stop doing so.  And we definitely know that nothing will appreciate forever!

The difficulty with value investing is knowing when an asset is cheap.  In the early days of investing, the concept of book value was very useful.  This is simply the accounting value.  If a company owns a factory and some machinery, the book value will be close to the value for which the factory and the machines could be sold. If you can buy a share, or a slice of the company, for less than the book value per share, you should.  

One top course is: https://online1.gsb.columbia.edu/value-investing

Book Value

Book value is still very useful on many occasions.  But modern companies are very complicated, and often much of what they do cannot be valued simply.  A lot of their worth might be tied up in software, for example, which is harder to value than a building.  Or they might own a lot of IPR — intellectual property which again, is intangible and hard to value.  But the effort is worth it.  Finding a cheap company to buy is one of the best ways to trade successfully. 

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Psychology as an Aspect of Investment Style

I have written a lot about the importance of psychological factors in investing.  It is absolutely crucial that you understand these, for two reasons.  Knowing about your own psychology will help you understand and improve your decision-making processes. It will be especially valuable to know when cognitive biases are likely to cause you to make errors in evaluating investments.  But just as important is knowing how other investors will think — after all, they have the same psychology as you do!  And knowing what other investors are likely to think of an asset is the key.  Because you want to find an asset which is not just cheap — but unjustifiably so.  Then you can expect it to go up sustainably.

See also: https://timlshort.com/2018/09/29/value-investment-buy-bank-stocks/ for how to implement this.