Two Great Approaches to Investing

My fellow Fool over in the USA, Morgan Housel, recently shared one of the things that drives him crazy about finance.

And, it’s really about two different approaches to investing.

Buying cheap is all that matters for some…

On one camp, you have investors like James O’Shaughnessy, author of one of the best tomes on investing around titled What Works on Wall Street (it’s called a tome because the book’s 680 pages long – I kid you not, I own it).

Housel summarised O’Shaughnessy’s conclusions about what really works in investing in the USA in four simple steps:

  • Buy cheap stocks, ranked on various metrics like price to earnings and price to sales
  • Make sure they’re financially sound stocks. Avoid highly levered companies
  • Buy a basket of them
  • Rebalance your portfolio once a year, selling what’s expensive and what’s cheap

O’Shaughnessy has shown such an approach can really work and in fact, he’s not alone.

Other professional investors like David Dreman have also back-tested similarly-constructed portfolios in the USA and found them to be more than capable of beating a broad stock market index. Some of Dreman’s work can be found in his book Contrarian Investment Strategies: The Psychological Edge.

Back home in Singapore, we also have Teh Hooi Ling’s research to thank for in showing how buying cheap shares can work. Teh, who’s currently the head of research at the investing firm Aggregate Asset Management, wrote an article titled “Time the market based on valuations” that was published in the 13 Oct 2013 edition of The Sunday Times.

She showed how a portfolio consisting of Singapore-listed shares with a low price to book ratio did a lot better over the long-term than one with shares that carried a high price to book ratio.

There are certainly different nuances with O’Shaughnessy, Dreman, and Teh’s research work, but the conclusions are similar: buying a basket of cheap shares works, ‘quality be damned.’

O’Shaughnessy encapsulated the thinking of the trio neatly by saying “a great company’s not always a great stock, just as a great stock isn’t always a great company.” To them, the cheapness (ranked in whatever valuation metrics they favour) of a share is paramount, regardless of the quality of the businesses it’s in.

What does ‘cheap’ look like

To give you an idea of how ugly cheap stocks can be, let’s look at what Singapore’s market has to offer.

The Straits Times Index (SGX: ^STI) is currently selling for less than 13 times earnings. At such a valuation measure, shares with price to earnings (PE) ratios of less than 6 can be said to be really cheap.

A quick filter throws up a few names like Rickmers Maritime (SGX: B1ZU). It’s a business trust that owns and operates containerships under long-term fixed-rate charters to container liner shipping companies.

While it carries a trailing PE ratio of 5.6 and can said to be cheap, its units are probably cheap for a reason: Rickmers’ distributable income has fallen by almost 80% from US$76m in 2009 to US$16.9m in the last 12 months.

For others, buying quality is paramount…

Moving on to the other camp, you have investors like Warren Buffett, Charlie Munger and Philip Fisher who believe in quality more than cheapness. Admittedly, they’ll much prefer to buy good businesses at cheap prices too.

But, they are also convinced that paying-up for good businesses – ones with strong intangibles like a powerful brand name, management with integrity, and deep and wide economic moats amongst others – would pay off over the long run.

Here’s how Charlie Munger once described it:

Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If a business earns six percent on capital over forty years and you hold it for that forty years, you’re not going to make much different than a six percent return – even if you originally buy it at a huge discount.

Conversely, if a business earns eighteen percent on capital over twenty or thirty years [one hall mark of a good business], even if you pay an expensive looking price, you’ll end up with one hell of a result.”

And this is what drives Housel mad: Both approaches work even though they might seem to be at odds on the surface.

Buying quality in Singapore

For an idea of how buying quality can work here, we can flip back to six years ago on 11 Oct 2007 when the STI hit its pre-crisis peak of 3,876 points.

Healthcare provider Raffles Medical Group (SGX: R01) and retailer Dairy Farm Holdings (SGX: D01) were both selling for ostensibly high valuations at 24 times and 30 times trailing earnings back then.

Both companies had results that proved remarkably resilient during the recession that engulfed much of the global economy in 2007 to 2009, and also carried strong balance sheets even in the toughest of times. Those are some hallmarks of quality there.

Today, RMG and Dairy Farm’s shares are both up by around 110% even as the STI is still down by more than 20%.

That’s how buying quality can work for you.

Foolish Bottom Line

In summary, we have successful investors on one hand saying ‘buy stocks cheap and forget about quality!’ On the other hand, we find other equally successful investors saying ‘buy quality stocks even if you can’t really get them cheap!’

Both approaches are right and Housel’s take away from this was both simple and profound:

Investing is not a hard science like chemistry or physics. There are no laws or unbreakable rules. Equally smart people can have opposite views and, oddly, be equally successful. Keep this in mind when determining what works.”

For me, it just shows that there are many roads leading to Rome. But if we look beneath the surface, there is a similarity. Both approaches look at stocks as a business – that’s the common thread. And, that is what really works.

Click here now for your FREE subscription to Take Stock Singapore, The Motley Fool’s free investing newsletter. Written by David Kuo, Take Stock Singapore tells you exactly what’s happening in today’s markets, and shows how you can GROW your wealth in the years ahead.  

The Motley Fool’s purpose is to help the world invest, better. Like us on Facebook  to keep up-to-date with our latest news and articles.

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing owns shares in Raffles Medical Group.