Benjamin Graham, who is generally viewed as Warren Buffet’s mentor, has several rules about investing. One of his main rules is to always invest with a margin of safety. In other words, invest in stocks at a price that is low relative to a stock’s earnings and at a price that is less than the stock’s intrinsic value. Investors would be wise to follow Graham’s advice by purchasing stocks as cheaply as possible relative to their earnings and the value of their assets.
Unfortunately, many investors are frequently investing in high-flying overvalued asset classes that have been going up only to sell their investments after they have decreased back to fair market value. Investors might fare better if they utilize a process to identity the cheapest stocks and sectors when making investment decisions. One of the strategies my firm uses in our managed accounts is a smart beta strategy designed to own only the cheapest sectors of the stock market.
Investments that offer investors the opportunity to buy the most earnings for the lowest price are considered the cheapest. However, sometimes a stock or a sector may appear to be cheap, but the fundamentals of the stock may be on a downward trend, which will result in even cheaper opportunities in the future. Instituting a screening process that can help avoid a stock with poor momentum — even though it may appear undervalued — is critical to avoid what is known as a “value trap.”
The smart beta strategy I alluded to above was developed by Yale economist Robert Shiller. The strategy allocates investments only into the cheapest sectors of the S&P 500 and rebalances each month. According to Morningstar, over the last five years Shiller’s strategy had not only significantly outperformed the S&P 500 index but has done so with much less volatility and much lower drawdowns than an investment in the S&P 500 index.
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