Excerpt from "The Philosophy of Investment".
Author: Aswath Damodaran (Note: Aswath Damodaran is one of the world's leading valuation experts. Damodaran has insights into value investing and growth investing that still influence us today.)

Different strategies of value investment:

Value investors are people looking for cheap goods. Some value investors use specific criteria to screen stocks that they believe are priced below their actual value and then make long-term investments. Some value investors believe that they can find cheap stocks after a stock market crash. Some value investors take proactive measures, buying stocks of listed companies that are priced lower than their actual value and poorly managed, and then strive to push for changes that can release the actual value of the stocks. Value investing has both empirical evidence in financial theory and real-life examples to support it. The legendary stories of Benjamin Graham and Warren Buffett have created myths about investments. However, successful experiences in value investing are not valid for all value investors.

The difference between value investors and other investors is that they expect to buy stocks of companies whose existing assets are worth more than their prices. Therefore, value investors are generally careful about stocks that the market pays a large premium for growth opportunities and seek to find the cheapest stocks in companies that have fallen out of favor and are relatively mature. Based on this, Damodaran found that there are two significantly different categories of value investing: passive screening and reverse value investing.

1. The great practice of passive screening:

Passive screeners screen companies for investment using specific criteria, such as low price-to-earnings ratio, market value, and very low risk, and investments that pass the screening are classified as good investments. Passive screeners believe that stocks with certain characteristics - well-managed, low-risk, high-quality yield - will perform better than other stocks. The key to successful investment is to find out these specific features. They are always looking for these features. Graham in his classic work "Securities Analysis" turned these qualitative features into quantitative screening for promising investments.

Graham once put forward ten screening criteria. He believed that any stock that passed these ten screening criteria was worth investing in. Subsequently, the conclusion drawn by researchers from these screening stocks investment portfolios was that investors could indeed achieve annual rates of return far higher than the market. But the only discordant note was that the attempt to transform Graham's screening into providing high-yield mutual funds failed. In the 1970s, a man named James Ray fully believed in the value of these screenings and created a fund. The fund invested in stocks based on Graham's screening. Although some initial investments were successful, the fund ran into trouble in the 1980s and early 1990s.

The greatest support for Graham's value investing comes from his students taught at Columbia Business School. Although these students have chosen various paths, most have achieved great success. Among them, the most outstanding student is Warren Buffett. Damodaran believes that Buffett's continuous success cannot simply be attributed to luck. Although he has also experienced difficult times, he immediately turned the tide in the following years. The secret of his success lies in his long-term vision, as well as his discipline - not changing investment principles due to short-term losses.

In fact, Buffett's investment strategy is much more complex than Graham's initial passive screening approach. Unlike Graham's conservative investment principles, Buffett's investment strategy extends to more diverse companies, from blue-chip stamps to Coca-Cola to Apple. Although both Graham and Buffett use screening to find stocks, the main difference is that Graham strictly follows quantitative screening methods, while Buffett is more willing to consider qualitative screening methods.

Interestingly, Buffett's investment method is not complicated at all. But we cannot see other investors using his method to repeat his success. This is because:

①The market has undergone huge changes. Buffett's greatest success occurred in the 1960s and 1970s. Damodaran believes that if Buffett were to start again in today's market conditions, he would probably find it difficult to replicate his past success.

②In recent years, Buffett has adopted a more aggressive investment style and has achieved success. But it requires a lot of resources as an investor, as well as credibility required for successful investment.

③If there are fundamental changes in the macroeconomic characteristics, the method of buying good companies at low prices and holding them for the long term, as Buffett did, may not necessarily bring ideal results as in the past.

④Patience. Buffett buys companies that are beneficial for long-term interests, and he often holds stocks that he thinks have poor performance but undervalued for years and endures years of low prices.

In summary, it is easy to see how Buffett has succeeded, but it is difficult for an investor to replicate his success.

2. Two forms of reverse value investing:

Reverse value investing is about buying assets that have been left untouched by other investors due to poor past performance or bad news. It is based on the premise that markets tend to overreact to good or bad news. In the long run, a stock that has performed particularly well or badly in one phase will generally exhibit the opposite situation in the next phase, but the phase cycle should be measured in years, not weeks or months. There are many forms of reverse investing, among which the most important are buying losers and expected value games.

① Buy losers, not winners.

The Damaradaran showed in negative serial correlation that stocks themselves will eventually see a reversal after a relatively long period of time. Stocks that have fallen the most in the past five years are more likely to rise than other stocks. In 1985, Richard Taylor and Warner De Bondt proposed one of the most important findings of behavioral finance in the article "Do Stock Markets Overreact?": Over a 3-5 year cycle, stocks that previously performed poorly begin to get out of their slump and former winning stocks begin to decline.

Studies show that these findings may be significant, but may also exaggerate the potential returns of a portfolio of losers for three reasons. First, portfolios of losers tend to produce uneven or unequal returns, meaning excess returns come from the performance of several stocks with unusually good returns, rather than the overall performance of the portfolio. Second, when the stable size cannot be controlled, loser stocks perform better than winner stocks; when the market value ratio is equal to both, the only month in which the former outperforms the latter is January. Third, although prices may eventually reverse over a long period of time, over a shorter period of time, loser stocks tend to continue to lose money and winner stocks tend to continue to profit.

In their research, there were two interesting findings. In the first 12 months, the portfolio of winners actually outperformed the portfolio of losers; although after 12 months, loser stocks began to catch up with winner stocks, in the years 1941-1964, it took 28 months for them to surpass winner stocks. In 1965-1989, loser stocks took even longer - 36 months - before they overtook winner stocks. The benefit of buying a loss-making company depends mainly on whether you have the ability to hold onto the stock for the long term.

② Identify expected value games.

Any investment strategy that aims to buy well-run companies in the hope that their earnings growth will push their stock prices upwards may be risky because it overlooks the possibility that the current price already reflects the company's management and asset quality. If the current price is right, the biggest risk is that the company will lose its luster over time and the market's reward will run out. Even if the company's value is overestimated by the market, this investment strategy will lead to poor returns even if the company is growing. The only time this strategy can earn excess returns is when the market underestimates the quality of the company.

Investing in well-managed companies does not always pay off. In his book "In Search of Excellence," Tom Peters summarized some of the traits that set companies with outstanding performance apart from all other companies in the market. The financial condition of companies with excellent performance may be better than that of those without, but those with ordinary performance are still a better investment than the former during the observation period. Although the study did not consider risk factors and the investment period was short, it provides evidence that good companies may not always be good investments and bad companies may also become good investments. This is what Howard Marks calls buying well, not buying good.

Underperforming companies are not necessarily poorly managed. In many industries that have been in a slump for a long time without any signs of a turnaround, these companies may continue to underperform in the future. However, if other companies in the industry where underperforming companies are located are performing well, the chances of success may be higher. Only companies with the potential to improve can see their share prices rise. Therefore, investors who wait for the lowest prices before investing cannot adopt this strategy, as it is almost impossible to determine the appropriate timing.

We must accept the fact that some poorly managed companies sometimes or often get worse before they get better, and this scenario may harm the investment portfolio in the short term. Therefore, buying loser stocks or stocks of poorly managed companies does not guarantee success, and this strategy may also prove unrealistic. Unless investors have a long-term investment horizon, diversify their investments, and have personal qualities, then it is another matter.

II. Strategies have advantages and disadvantages.

Like value investors, growth investors also value value, but their key difference is where they look for value. Value investors believe they are more likely to find assets that are undervalued by the market and are more willing to invest in mature companies with lots of existing assets but poor performance. Growth investors believe they are more likely to find cheap stocks in growth investing. The most effective way to build an investment portfolio is to screen for stocks based on specific screening indicators. There are three screening strategies for growth investing: high-growth stock strategy, high-PE high-risk strategy, and reasonable price growth strategy.

1. The uncertainty of the high-yield growth strategy.

This is the most reasonable strategy followed by most growth-oriented investors when buying stocks with a high growth rate, but past growth rates do not necessarily accurately represent future growth rates. Past growth rates help predict future growth rates, but there are two problems with past growth rates:

First, for many companies, if past growth rates are not a reliable indicator of future growth, they cannot rely on them to predict the future. In addition, the growth rates of small companies are more volatile than those of other companies in the market. Therefore, one should be cautious when using past revenue growth rates to predict a company's future revenue growth.

Furthermore, for companies that undergo rapid development today, their development speed will slow down and approach the market's average development level. Those companies with below-market-average development will experience an increase in their growth rate. Although in the year in which the investment portfolio is formed, the company with the highest revenue growth rate may have a higher average growth rate than the company with the lowest revenue growth rate. After five years, this difference can be ignored.

In general, income growth rates are more sustainable and more predictable than earnings growth rates. However, past earnings growth is not a reliable basis for predicting future growth. Investing in companies with high past growth rates cannot generate high returns. If there is mean reversion, and investors overpay for stocks of companies with high growth, they will eventually find that their investment portfolio is losing money. The intrinsic value of a stock ultimately depends on future growth, not past growth.

Therefore, it makes sense to invest in stocks with high expected future growth value rather than in stocks that have experienced a large past growth rate. However, in the securities market, we cannot estimate the price of every stock on the market. To make this strategy successful, one must be good at predicting long-term revenue growth and the market price should not already reflect this growth or price growth too high.

2. Limitations of the high price-to-earnings ratio strategy.

According to Damodaran's research, the overall evidence for buying high price-to-earnings ratio stocks is brutal. The results of investing in low price-to-earnings stocks seem to be much better than investing in high price-to-earnings stocks. The reason investors adopt the high price-to-earnings ratio strategy is because of the investment cycle. During periods when the market's revenue growth is in a trough, growth investing seems to perform much better, while value investing tends to perform better when revenue growth is high. The best performance of growth investing occurs during months/years of low revenue growth, which may be because during periods of low revenue growth, investing in growth stocks is ideal, as growth stocks are scarce during this time. The most interesting evidence for growth investing is the percentage of fund managers who beat their respective benchmarks. When measured against their respective benchmarks, the percentage of active growth investors who beat the growth index seems to be higher than that of active value investors who beat the value index.

3. The most reasonable price appreciation strategy may not be the optimal one.

For investors who fear buying high price-to-earnings stocks, their goal is to buy high-growth stocks that are priced low. This involves two strategies: buying stocks whose price-to-earnings ratio is lower than expected growth rate or buying stocks whose price-to-earnings ratio to growth rate ratio (PEG) is low.

① Price-to-earnings ratio is lower than growth rate. The obvious advantage of this strategy is simplicity, but it also carries inherent risks. One is the influence of interest rates. When interest rates are low, the value created by any growth rate is greater than that created when interest rates are high. The second is the estimation of growth rates. Given that the estimated growth rate is at most 5 years, focusing only on the 5-year growth rate is disadvantageous to companies with higher growth rates over a longer period. In low-interest rate environments, there are few companies that can be invested in after screening, resulting in almost no stocks.

② PEG, price-to-earnings ratio to growth rate ratio. The study found that using the strategy of buying stocks with low PEG ratios resulted in significantly higher returns than those obtained by investing in the S&P 500. However, PEG may cause us to mistake stocks with high growth rate risks as pricing low. The PEG ratio is calculated by dividing the price-to-earnings ratio by the expected growth rate, and the uncertainty of the expected growth rate is not factored into the PEG ratio. Therefore, stocks that appear cheap according to the PEG ratio may actually be priced correctly or priced too high.

When we use the PEG ratio, we have an unclear assumption that if the growth rate doubles, the price-to-earnings ratio will also double; if the growth rate halves, the price-to-earnings ratio will also halve. Assuming a linear relationship between price-to-earnings ratio and growth rate is incorrect. When the expected growth rate is low, the PEG ratio is highest, but when the expected growth rate increases, the PEG ratio decreases. The problem is most serious when comparing high-growth companies with low-growth companies, which is because the PEG ratio of high-growth companies is under-reported, while the PEG ratio of low-growth companies is over-reported.

Therefore, growth investors must make more precise estimates of growth. The success of growth investing ultimately depends on the ability to predict growth rates and price them correctly. If a person excels in this area and outperforms the market, the chances of success will increase. Historically, growth investing performs best when the market's revenue growth is low and investors are pessimistic about the future. However, to become a growth investor, one must be willing to accept short-term abnormal returns (that is, returns that are either higher or lower than the mode) and invest in the right companies.

No strategy is flawless, and there is no such thing as an absolutely optimal strategy for any investor. If one blindly follows a strategy, success cannot be achieved. Dogmatism can only lead us into one trap after another. Therefore, we need to choose the most suitable strategy for ourselves to adapt to this capricious market, and then we have the possibility of survival in the long run.

Editor/Lambor