Think Like the Great Investors by Colin Nicholson

Author:Colin Nicholson
Language: eng
Format: epub
Publisher: Wiley
Published: 2013-05-14T16:00:00+00:00

Summary

Overreaction occurs when investors place too much weight on recent information. Research confirms the theory that bad news leads to overreaction. In particular, a wide portfolio of stocks that have low PE ratios is likely to outperform over the next three years, which is a large part of the rationale behind value investing. However, this effect is valid only for a wide portfolio of low PE stocks, not for any one or a small number of low PE stocks.

Strategies

1 Look to take advantage of unwarranted overreaction. If a stock is sold off sharply on some bad news, ask whether the reaction is overdone by focusing too much on the very short-term picture rather than the longer term picture. If we think it is, and that the stock is relatively undervalued, we might buy it or buy more of it if we already own it. However, it is also important to recognise the risk that we could be wrong on our assessment. Markets can behave irrationally for longer than our capital will hold out. Therefore, it is important to set a level below which we are no longer willing to allow the stock to fall and to sell promptly if it happens.

2 Construct portfolios of undervalued stocks rather than follow the soaring trends of momentum stocks that tend to be overvalued. The important thing is to hold diversified portfolios of undervalued stocks. Spread the portfolio across a number of industries and avoid holding too many stocks in any one of them. Of course, some undervalued stocks will not rise. For them, there is a need to be disciplined in selling if their price falls to a level at which we are no longer prepared to continue to hold them. Even more important is the understanding that the value investing research applied to a large, widely diversified, portfolio of undervalued stocks. The law of small numbers discussed in the previous chapter does not apply: they will not all rise, but the portfolio as a whole is likely to rise more than the market. Most of us will not have enough capital to hold a wide portfolio of stocks. Therefore, the value investing style is only a rough starting point. It is reversion to the mean for a large sample. No matter how undervalued stocks are, it does not mean that any one of them, or any small number of them, will outperform the market. In selecting which small number of undervalued stocks to buy for our portfolio, we need to bring to bear many other disciplines.

3 If we have bought an undervalued stock and after a few years its fortunes turn around magnificently and its price soars, we might take advantage of the tendency to overreaction. Suppose the price has risen such that the stock is now no longer undervalued, indeed no longer even fairly valued, but greatly overvalued, then we might consider that the risk on the downside is now very high. It may be a time to capture the excess price that is due to overreaction, and so will not last, by selling and switching to a new undervalued stock.

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