This article is part of Morningstar's Guide to Financial Education
Have you got the right temperament to be a successful investor? There are as many different styles to investing as there are brands of coffee, or manufacturers of cars – but there are certain maxims that the greats swear by. If you follow these rules to paraphrase the Sage of Omaha, you don’t need to be a rocket scientist to achieve investment success.
Look for the Underdog
Value investing is the art of buying an asset that is trading at less than its intrinsic value. Famous value investor Warren Buffett has mastered the art of buying companies that the market has underestimated. He identifies companies that he thinks are undergoing a temporary blip, but are fundamentally sound, and when they experience a price correction he sells them on and takes a healthy profit.
“The best thing that happens to us is when a great company gets into temporary trouble. We want to buy them when they're on the operating table," he said. The key is making sure that you are buying a good quality company – some stocks after all are cheap for a reason.
"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price," Buffett has said in the past.
Value investor Nick Kirrage, who runs the Schroder Recovery fund, uses the Graham & Dodd price earnings ratio to calculate the level of return he can expect from an investment in the future. P/E is a measure of how cheap a stock is, generally speaking the lower the P/E number the better value the stock is. It is calculated by dividing the market capitalisation by profits available to shareholders. The Graham & Dodd P/E is cyclically adjusted which helps smooth out anomalies.
Historical data shows a correlation between the Graham & Dodd P/E and future returns. The data shows that companies with a P/E of between five and 10 return an average annual yield of 11% annually for the following decade.
If you don’t have the time or inclination to evaluate a company’s balance sheet yourself, call upon the experts. Morningstar equity analysts use their research to determine a share’s Fair Value, and from this they award it a star rating. A stock with a five star rating is trading at significantly less than its Fair Value – and one that has been awarded one star is considered by analysts to have a share price much greater than the Fair Value estimate.
Don’t Go with the Flow
While being easy-going might win you friends, it won’t win you investment success. Herd mentality is the act of moving with the crowd – becoming an investment sheep. It is this herd mentality which caused thousands of investors to pour money into the stock market at the turn of the century when the FTSE 100 was at its peak just before the dot com bubble burst. Similarly this herd encouraged good money after bad into corporate bond funds in 2012 when the asset class was already over-heating. The trick is to be contrarian, and ignore both the hype and the naysayers. Sticking to strong investment fundamentals, such as value investing and asset diversification will serve you better than the clamour of the crowd.
Be Loyal to Your Portfolio
While it is tempting to abandon what looks like a sinking ship, it is important to show your investments a bit of loyalty. Morningstar fund analysts only consider past performance as one of five factors when awarding a rating as they recognise that even the best managers in the business are prone to a period of underperfomance.
If you skip out on a stock or fund that you have held for a short period of time just because it is showing volatility you risk crystalising your losses and missing out on the upturn. Instead, if the rest of the fundamentals are compelling, consider adding to your position during the blip and reaping the rewards when the price is rerated.
