This week’s post is a bit of a rant I’m afraid! I’ve highlighted a handful of fairly common ideas in investing that have managed to get under my skin. They are common but don’t make much sense and I feel compelled to debunk them. Some you could put down to differences in perspective I suppose, but some are just downright wrong.

‘You should sell your losing investments, because you will have to earn a greater percentage to get back to break even.’

I’ve come across this advice on several occasions. It’s cropped up in a couple of otherwise decent books, including Mark Minervini’s books and in ‘The art of execution’ by Lee Freeman-Shor. The argument goes something like: because of the mathematics of compounding, the more you lose the harder it is to get back to break-even. If you lose 20% on an investment, you will have to earn 25% to get back to break even again. If you lose 50%, you need to earn 100% etc. Therefore you should cut your losses when they are smaller and easier to get back from, for example by using a stop loss.

This line of argument is highly illogical. It is true that the compounding of returns means that your portfolio should make exponential rather than linear progress (whether increasing or decreasing in value). However, this doesn’t dictate whether should stick with your current losing investment or switch to another. The reasoning commits the sunk cost fallacy – costs that have already been incurred should not affect your current decisions. Investment losses are ‘sunk’ (already lost) whether you continue to hold your current position, or decide to sell and reinvest the proceeds in another investment. You don’t get to magically erase your loss and start again by selling your position. Either way you need to earn a higher percentage than you lost on what you have left to get back to break-even.

Cutting losses does make sense, but because of the momentum effect, not because the mathematics of compounding.

‘Value investing is a long term strategy’

When I started out in investing, most of what I was reading was about value investing: buying shares for less than their intrinsic value when they were temporarily out of favour. One thing that seemed to be stressed often was how value investing is a long term strategy. Value investors are encouraged to be patient, ignore short term fluctuations in share prices and wait ‘for value to out’ up to five years if necessary. Many value investors even describe their investing style as ‘buy and hold’.

For example, have a look at Schroders: The Value Perspective. In it they put forward the idea that value investing is a long term approach. They also state that the key driver of equity returns is the price you pay (i.e. presumably the valuation), rather than the growth you get. As well as being plain wrong (obviously both price and growth are important parts of the equation), the focus on valuation rather than growth is by its nature more of a short term perspective. Obviously what matters more in the long term is how well the business does over the long term i.e. growth.

The idea that value investing is a long term approach has always grated with me. There is a logical inconsistency between the idea of looking for shares which have low valuation multiples, indicating they may be temporarily out of favour, and a long term buy and hold strategy. The true value investor is looking to benefit from mean reversion, which by its nature is a temporary phenomenon. A value investor might hope to generate a decent return by buying a share they think is 50% undervalued and so they hope would double within 1-5 years. I wouldn’t describe this as a long term approach.

To some extent this is a question of perspective. Value investing is clearly a longer term strategy than speculating over day to day or month to month price movements. However, for me ‘long term’ implies selecting investments that one would expect to outperform for decades. For this, cheap looking valuation multiples are insignificant compared to the ability of the business to deliver sustainable long term compound profit growth.

‘XYZ Ltd is trading on a 20% discount to its historical average’

This is something you would more commonly see from lazy financial journalists rather than serious investors: the idea that something is cheap because it is trading at a lower valuation multiple than it has in the past. However, this type of comparison is generally totally meaningless.

The obvious problem is that it doesn’t compare like with like. A business’s future prospects will change over time and so should its valuation: a lower valuation may often simply indicate that prospects have deteriorated. On top of this, you would expect most businesses to grow more quickly when they are smaller – this means their valuation multiple should decline over time if they continue to be valued fairly.

A similar error is to compare valuation multiples across businesses in a market or industry sector. Again this doesn’t compare like with like. Often the businesses models aren’t quite the same and some businesses are simply better than others or at different stages in their development. If anything you would probably tend to be better off if you always bought the most expensive-looking business in a sector, as it is likely that others are biased towards the cheaper looking ones without fully appreciating the qualitative differences. Better still is to avoid this sort of meaningless valuation comparison altogether.

‘A PEG ratio of below 1 is cheap’

The Price Earnings Growth (PEG) ratio is calculated by dividing the price earnings (PE) ratio by the expected growth rate. A lot of investors seem to use it by plugging in the forward PE ratio and analysts expectations for next year’s growth. If the PEG ratio is less than 1 then the stock is cheap.

While the idea of trying to incorporate future growth into valuation is laudable, in my view the PEG ratio is best avoided. There is so much wrong with it it’s hard to know where to start. Firstly, the parameters you are supposed to put in are not clearly defined: should it be the current or forward PE ratio? More importantly, should it be the historic growth rate, next year’s growth rate, the average growth rate over the next X years? There is no correct answer to this. Second, there is no mathematical basis for dividing the PE ratio by the growth rate. Yes a lower PE ratio or a higher growth rate means something is cheaper, but as growth compounds the relationship between the two is far from linear. A share growing at 20% a year and trading at a PE of 20 is clearly a lot better value than a share growing at 10% a year and trading at a PE of 10, though the PEG ratio for either share would be 1. Finally, the benchmark of 1 that most investors who use the PEG ratio seem to follow is entirely arbitrary.

‘I’m really annoyed that one of my shares got taken over at only a 30% premium. It was worth a lot more’

I come across so many investors that say this. OK, most of them probably aren’t being serious, and mean it more as a confession of irrational love for their investment. But I’m not convinced this is everyone. If you do seriously think that your investment was better than a risk-free instant 30% return, then ask yourself this: ‘how come you hadn’t invested your entire portfolio in it then, with lots of leverage for good measure?’