Topic: Value Stocks

3 key investing concepts: the four-year rule, avoiding narrow value measures, and bottom-up investing

investing concepts

Here are some key investing concepts to help you select the best investments for your portfolio

An investor’s only real source of safer and steadier profits is to build the kind of portfolio that we create for our portfolio management clients. This kind of portfolio emphasizes investment quality, value and diversification.

Continue reading for three investing concepts we use in our stock selection.


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Investing concept #1: The four-year rule 

We’ve written about this at length many times over the years, because it is one of the most helpful rules we’ve ever come across. Here’s the short version: an attractive buying opportunity appears in North American stocks about every four years, usually within a few months of the U.S. mid-term election. Investors who buy around this time tend to make substantial profits over the next couple of years.

To put it another way, most North American market gains occur in the second half of the four-year U.S. presidential term. Big gains can occur at other times, of course, but this is the most reliable recurring pattern in the North American stock market.

That’s probably because U.S. presidential elections bring out many “swing voters” who might not vote in less important elections. When things are going well for them, these voters tend to favour the current officeholder. This has an impact on U.S. political office holders, regardless of party. They all want to get re-elected, or pave the way to the election of a successor from their own party. So, consciously or not, they work together to make swing voters happy during U.S. presidential elections. They start work towards that goal around midway through the four-year U.S. Presidential term.

The stock market never goes up steadily during the two years between a Congressional election and the next Presidential election, of course. But it does tend to rise at an above-average pace during those two years, mainly because U.S. office-holders are doing whatever they can to improve their chances for re-election. 

Investing concept #2: Don’t focus on single measures of value such as p/e ratios 

When they choose stocks, many investors try to cut their workload by taking a narrow view. Rather than looking at a wide range of information, they prefer to zero in on one or, at best, a handful of indicators. This can do more harm than good.

For instance, many investing newcomers get the idea that you should only buy stocks that trade at a below-average p/e ratio (the ratio of a stock’s price to its per-share earnings). Some go so far as to reject any stock that trades above some arbitrary cut-off, such as 10 times earnings.

This prejudice ensures that you will avoid some stocks at precisely the best time to buy, or buy others that you should avoid.

That drop in the p/e may make the stock seem like a safer buy. But by the time the p/e comes down to attractive levels, the stock may have already doubled or quadrupled. If you focus strictly on p/e’s, you will miss out on that rise.

Another problem with focusing on low-p/e stocks is that many disasters-in-waiting go through a low-p/e period prior to their eventual collapse. This low-p/e period occurs because people close to or involved with the company recognize that it has serious problems. They sell their own holdings, and they tell their friends and relations to do the same. (This pushes down the ‘p’ or price of the stock, lowering the p/e ratio.)

These problems can be due to a weakness in the business model, rising competition, doubts about the quality of the company’s management or insiders, or involvement in a business or industry that is headed for a downturn. When one or more of these problems flares up, it can devastate the company’s earnings overnight and send its p/e ratio sky-high.

To get any real value out of p/e’s, you have to look at them in the context of everything else that’s going on, in the market and in individual stocks.

Investing concept #3: Gains add up for bottom-up investors

Over periods of five years and beyond, top investment honours mostly go to members of the bottom-up crowd. That’s partly because bottom-uppers tend to make fewer big mistakes. This lets their gains accumulate. This also leads to longer holding periods, which provide greater tax deferral and lower brokerage costs.

The top-down approach appeals to beginning investors, when they have not yet learned how little they know. (That’s a good time for it, when you have little money to invest and can’t do yourself much harm.) By the time they build up enough of a stake to begin serious investing, most advisors and investors have settled on a mix of top-down and bottom-up. As years pass, successful investors tend to put more weight on bottom-up. They like the way it cuts risk.

What investing concepts do you rely on for your investment strategy?

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