Over the last decade, the FTSE 100 has recorded an annualised total return of around 9.5%. That’s an exceptional return, and suggests that buying a range of stocks within the index could be a sound move.
Of course, many investors may wish to try and obtain a higher rate of return than the wider index. Doing so, however, has proven to be somewhat challenging in the past, with many private and professional investors having underperformed the index.
With that in mind, focusing on the valuations of stocks could provide investors with an advantage, since it may allow them to improve the risk/reward ratio of their portfolios. This may help an investor to outperform the wider index.
Intrinsic value
Valuing a company is, of course, highly subjective. There are a variety of methods which can be used, including simple ratios such as price-to-earnings, or price-to-book. Other investors may prefer to discount future cash flows at a specific rate in order to ascertain their present value. Meanwhile, some investors may wish to focus on qualitative, rather than quantitative, measures when assessing a company’s value, such as the size of its economic moat.
However, if an individual decides to value a company, doing so could enable them to determine whether there’s a sound opportunity on offer. Investors such as Warren Buffett seek a margin of safety when investing, which means the price they pay needs to be significantly lower than their valuation of the company. This provides them with greater reward opportunity, as well as lower risk. In the long run, this could make a significant impact on the performance of a portfolio.
Discipline
Of course, many investors are well aware that value investing can have a positive impact on their long-term returns. The challenge in many cases is having the discipline to stick with the strategy throughout different parts of the market cycle.
For example, during bull markets, it may be challenging to find stocks which offer discounts to their intrinsic values. As such, investors may find there’s a lack of buying opportunities and end up with larger amounts of cash during such periods. In contrast, during bear markets, there may be significant opportunities on offer. But an investor could find it difficult to capitalise as a result of fears about the near-term prospects of the stock market.
In both circumstances, focusing on the long term could be a potential solution. Although bull and bear markets can persist for some time, they’ve never yet lasted in perpetuity. Therefore, buying opportunities will always come along, while a rise in the stock market is also very likely to take place in future. It may take some time for such changes to be delivered, but for investors who buy high-quality stocks at discounts to their intrinsic values, such periods can work to their advantage in helping them to outperform the FTSE 100 over the long run.
