Investors come in different styles. Analysts and mutual fund managers generally approach the task from a particular point of view. You have heard of “growth” managers and “value” managers. There are as many ways of analyzing investments as there are investment analyzers.
In my view, there are two and only two styles of investing. Value investing, and guessing. Any investment analysis not rooted in valuation is just guessing. You might as well flip a coin.
Humans like to control the outcome of decisions. At least, we like to imagine that we can. However, you need to understand a fundamental concept of investing: Once you make the investment, the eventual return on your money is utterly out of your control. You control things up to the point that you write the check or click the mouse button, and you then have to sit back and take whatever comes back. If you don’t like the results … well, too bad.
Before you write the check, you need to analyze the prospects for the investment. Since the amount of money that will eventually be repaid to you is beyond your control, you need to ascertain with as high a degree of certainty how much money will come your way. In the case of an income-producing investment, such as bonds or income property, this is not a complicated task. Bonds have the return printed right on them, and property will produce a relatively predictable stream of rental income.
Once you have these figures in hand, you can decide how much you want to pay for the investment. If the rental income from a building is $10 thousand per year, you know that paying $100 thousand for it will produce a 10 percent return; paying $200 thousand for it will produce a 5 percent return. You decide 5 percent is too low, so you offer $100 thousand for the building. Congratulations - you’re a value-driven investor.
Now let’s imagine that the building owner declines your offer and points to comparable sales at $200 thousand. The broker is telling you that buildings in the area have been going up at 20 percent per year, and that you will make plenty of money. How is this possible? The rental stream has been the same, rising only with inflation. If you go into this $200 thousand purchase price expecting to earn more than 5 percent, plus inflation, you are just guessing. You are guessing that another investor will come along and pay more for the building than you did. Is there anything in the numbers that leads you to believe this will happen?
What would have to occur for someone to come along in two years and pay you $250 thousand, when the rental income is still only $10 thousand? That new investor will have to accept a rental yield of 4 percent. What would lead you to believe that will actually occur? A simple guess, that’s all.
I do not mean to suggest that so-called growth investments are a bad thing. I want the earnings of my stocks to grow as fast as possible. I merely insist that the price we pay for the stock is rooted in a sensible evaluation of its true worth. The very best “growth stock” managers use a valuation discipline to choose fast-growing stocks. The worst growth stock managers seem to just jump on the bandwagon and guess that other investors will come along and trade places with them before the wagon runs off a cliff.
All investment analysis must address the questions: What are the prospects for the future return of my money, and how much am I willing to pay for that stream coming back to me? I need to adjust the price downward if the return stream is uncertain or risky, and perhaps upward if the return stream is quite safe. In either case, I use the simple tools of valuation to guide my decisions.
Whether it is stocks or real estate or foreign government bonds, all wise investment decisions are rooted in valuation. The only thing you can control is the decision over how much to pay for an investment.