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Closing the Gap

A valuation perspective can spur better investor outcomes.

Haywood Kelly, 09/30/2014

This article originally appeared in the October/November 2014 issue of Morningstar magazine. To subscribe, please call 1-800-384-4000.  

In investing, there’s a long list of events we can’t control—wars, currency crises, economic stagnation, the level of interest rates—and we manage these risks for ourselves and for our clients as best we can through diversification. But there are a few things completely within our control, which in theory should be easier to manage. One of these is the timing of our purchases and sales. Unfortunately, the numbers suggest that we do quite a bit of damage to our portfolios through poor timing. At Morningstar, we’ve been educating investors about these controllable risks for years, and our ongoing work on valuation can (we hope) arm investors with more tools to make better timing decisions. To get a sense of the money we leave on the table through poor timing, Morningstar publishes fund-by-fund data comparing investor returns— the returns actually achieved by the average investor in a fund—versus the straightforward, as-reported return. According to Morningstar research, the typical fund investor gained 4.8% annualized over the 10 years through December 2013 versus 7.3% for the typical fund. Why is that? Mainly because, on average, investors tend to chase returns. Retail investors, financial advisors, institutional investors— we all do it. We’re all hard-wired to salivate over what’s going up.

To understand why we think a valuation focus is an important key to helping correct this behavior, recall this handy formula for thinking about equity returns:

Put another way, the total return of a stock is a combination of the true underlying growth in a company (represented by dividends and earnings) and a healthy dose of animal spirits (represented by changes in valuation). To correct for bad timing, the knee-jerk contrarian impulse would urge us to avoid what’s gone up and buy what’s gone down. And while there is merit in the skepticism implied by the contrarian stance, there’s usually a very good reason an asset price has moved up or down. What we really need to worry about is the subset of investments that look questionable because of animal spirits. If you purchase an asset for too high a price, you’re bound to be disappointed.

That’s where our valuation tools come in. For equities, we build a valuation view one stock at a time, and we can then aggregate those bottom-up valuations to judge which pockets of the market—or as in the graph, the overall market—are trading rich or cheap.

Did you really want to bail out on stocks in March 2009, when the median stock was trading at just 55% of fair value? Of course not. But a lot of people did just that, missing out on one of the great stock market rallies of the postwar era and driving another huge wedge between official fund returns and actual investor returns. Even if such valuation considerations only influence your decisions at the margin, the implications of a cheap or expensive stock market are significant. If the market is rich, those might include a slightly higher tilt toward cash or a measured approach to investing new monies in the stock market (through a drawn-out dollar-cost averaging plan, for example).

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