Beat the Market with a Value Investing Portfolio

This article on how you can beast the market with a value investing portfolio  was written by Josh Klein. Josh is a private investor and a commercial real estate analyst from New York City. He combines balance sheet health with operational efficiency in his personal account. Article image (Creative Commons) by Geraltedited by The Broken Leg

Has it ever dawned on you that many professional investors have been able to generate outsized returns while some of their stock picks have performed poorly? How is this possible? How can professionals be wrong yet still succeed? Investors use different strategies, but are there universal methods they use to maintain high returns even when a few stock ideas don’t work out?

The key is understanding how to construct a balanced value investing portfolio the right way. Although some of the stocks might disappoint, over the long run the portfolio – i.e. the collective group of undervalued stocks – will do well.

With market volatility at an all-time high, it is essential to create a sound value investing portfolio that can withstand major market fluctuations. Maintaining a consistent strategy helps remove the emotional biases that come along with stock market investing.

Without formal criteria for stock picking and portfolio allocation, deep value investors can be subject to fears and irrationality. A major price drop, an unforeseen event, or a market correction can all taint the investor’s long-term outlook. If the investor begins to lose their calm, they will lose their edge over the crowd and begin to suffer abysmal returns. Establishing a good value investing portfolio – focusing on the collective group of holdings over any individual stock – is not only a good way to outlast Mr. Market, but it’s the only way.

How do investors adopt a working strategy? Easy – learn from the greats.

Find a Strategy That Works for Your Value Investing Portfolio

Creating a firm value investing portfolio is no small feat. It requires quite a bit of research and patience. Fortunately for the modern day investor, investment analysis and research has been developing for quite some time.

As Sir Isaac Newtown once put it,

“If I have seen further it is only by standing on the shoulders of giants.”

Giants such as Warren Buffett, Joel Greenblatt, Benjamin Graham, Mohinish Pabrai, Seth Klarman, and David Dreman all pioneered unique investing philosophies and constructed different – yet highly successful – value investing portfolios. Basing your strategies on their work is a great place to start your journey.

The first step in amassing strong long-term returns is finding an investment strategy that works for you. Buffett’s free cash flow and economic moat investing strategy has worked wonders for him over his 50-plus-year investment career, but it’s a mistake to think that retail investors can replicate the master using this approach. That does not stop many investors from falling into the Warren Buffett trap, however.

Greenblatt’s deep value magic formula investing methods have produced incredible gains for his fund, Gotham Capital, over long stretches of time. This is a much more practical approach to investing for the small investor, though we think there are better deep value strategies.

David Dreman ’s deep contrarian outlooks on the markets have worked, as well. Dreman incorporates a range of contrarian strategies that many investors have employed to beat the market. Reading about David Dreman’s investment strategy is an important early step for aspiring deep value investors.

Find a strategy that speaks to you and begin doing some research. Feel free to blend certain criteria together and formulate your own strategy. Whatever the case may be, the first step to an exceptional value investing portfolio is consistency in your investment philosophy.

Adopt a Value Investing Portfolio Checklist

After choosing a strategy that makes sense, the investor must systematically search for stocks that work well with that strategy. Stock screeners such as Net Net Hunter and deep value investment letters (like The Broken Leg Investment Letter) are great places to sift through the world of stocks from a deep value-oriented perspective. Create a checklist of certain immovable criteria that must be met in order to proceed with an investment.

For example, if your value investing portfolio construction strategy is a net asset value (NAV) approach, your checklist should contain items that fall into that bucket. The checklist would likely contain items such as net asset value to exceed current share price, positive earnings growth over the past three years, and insiders buying shares. Those are just a few examples of what could be added. However, if you are adopting a Greenblatt approach, you’ll likely have items such as a minimum return on equity (ROE) and return on assets (ROA) in your benchmark analysis. Whatever the case may be, the checklist items you set aside must be a rigid formula. The moment one deviates from a systematic investment approach, that’s the moment they begin to fall victim to their emotions.

Diversify Your Value Investing Portfolio Well

Diversification is essential when adopting a sound value investing portfolio. There is no “one size fits all” for proper diversification. One can elect to split up purchases based on asset class, market capitalization, industry, geographical region, or all the above.

What’s important, though, is to focus on the collective over the individual. Anyone stock might underperform in any given economic cycle, but that doesn’t define whether a strategy is unsuccessful. Purchasing a large block of 15-30 stocks using a rigid stock selection screen and portfolio allocation method will prove invaluable over the long-term.

Set It and Forget It

Once you’ve selected a sound value investing portfolio strategy, buy the stocks that fall under your criteria. Try to come up with a screen that is broad enough to allow you to fill your portfolio with a good number of positions, yet specific enough not to eclipse 30 – or so – companies.

Pick your stocks and purchase them with conviction. Don’t monitor the portfolio too intensely. Excessive thought and attention devoted to your set-it-and-forget-it value investing portfolio can prove to be detrimental. Unless you believe you have the mental and emotional wherewithal to stomach large periodic declines, refrain from dwelling over your short-term returns. A collection of deep value stocks isn’t designed to appreciate steadily. In fact, they usually gyrate heavily between values. Have faith in your analysis, ignore market sentiment, and trust the set-it-and-forget-it process.

Rebalance Appropriately

In order to maintain a successful value investing portfolio, one needs to re-evaluate their collection of stocks periodically. A poor rebalancing strategy can impact long-term returns drastically, so formulating a systematic approach is paramount. Deep value investors can best balloon returns by rebalancing once a year. Anything more frequent than that can impact returns with excessive fees.

Revisit your strategy and sell the stocks that no longer meet your set of criteria. If your companies still carry the appropriate metrics to fall under your strategy, dollar cost average to bring your entry points lower to enhance your future returns.

Conclusion

Evaluating stocks and discovering which fall in deep value territory is only the first step in enhancing your long-term returns. To limit downside risk, constructing a well-rounded deep value investing portfolio is essential. Pick criteria that speak to you and focus on the collective return rather than the individual. Returns don’t appear overnight. Believe in your conviction, perform the necessary due diligence, and trust the process. One need not look further than the successful careers of Greenblatt, Buffett, and the other greats mentioned above.

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