Patience provides the best returns

History has shown that buying undervalued stocks has reaped the highest returns over the long run. Cheap stocks have consistently beaten both the market and the glamour stocks that make for conversation at cocktail parties. But my hunch is few professional money managers actually adhere to the basics of value investing.

In his 1984 speech delivered on the 50th anniversary of Security Analysis, Warren Buffett gave a hypothetical example of a coin-flipping contest where 225 million Americans wagered $1 each. Everyday, the losers dropped out and the winners advanced to the next round, re-betting all their winnings. In 20 days, 215 people won over $1 million each. Buffett then replaced people with orangutans. The result was the same.

Advocates of efficient-market theory believe market outperformers are nothing but lucky coin flippers. But what if an overwhelming number of winning orangutans came from the same zoo?

In his speech, Buffett examined the records of some of the most successful investors of all time. The seven super investors he listed all came from the same zoo, so to speak. As Buffett put it, “There has been a common intellectual patriarch, Ben Graham. But the children who left the house of this patriarch have called their flips in very different ways. They have gone to different places and bought and sold different stocks and different companies, yet they have had a combined record that simply can’t be explained by random chance.” So what prevents investors and their advisors from adopting these methods?

Uncommon sense

Common sense dictates investors should buy low and sell high, but studies show most of investors do the opposite. The best time to buy stocks is when they’re on sale. However, when stocks are cheapest, investors find reasons not to buy.

When taking a value approach, treat your investment as if you were becoming part owner of a private business. Do research and due diligence. Value investing goes much deeper than trading pieces of paper on the stock market.

Understanding a business’s inherent value provides investors with confidence to invest at the right time. Every so often, the stock market presents opportunities to purchase businesses at a discount. And once you invest in an under-priced business, it’s your time in the market that counts—not market timing. You’re better off staying invested in stocks offering high potential returns.

In-and-out

Peter Lynch, the investor behind the successful market-beating Fidelity Magellan Fund, calculated that more than half his investors lose money. His fund was publicly traded; investors poured in after a couple of good quarters and exited after a couple of not-so-good ones.

According to Nobel Prize winner William Sharpe, a market timer must be right 82% of the time to match a buy-and-hold return. A lot of work for what could be achieved by taking a nap! Yet many market participants equate activity with intelligence. There is a common misconception that a portfolio manager is paid to act. But in reality, choosing not to act can be far more meaningful if it’s a result of careful research.

Investing requires patience. Ideally, a business’s value will rise gradually and the stock price will follow suit, allowing you to hold investments for many years.

Maintaining low turnover will minimize transaction costs and taxes, allowing maximum returns. If you made a $10,000 investment with a yield of 10% per year, and allowed it to compound for 30 years, you would only be required to incur taxes when the investment is sold. At a 50% marginal tax rate, you would be left with $133,000.

Yet if you continuously traded and still managed to earn 10%, you would constantly trigger taxes, reducing your return to $88,000. In other words, long-term investors take advantage of the tax mechanism and allow compounding to work its magic.

Timing turbulence

Do you have the temperament to weather the ups and downs? Performance over a quarter, or even a year, is not meaningful. After all, we don’t need to win every day; we just need to win over time. Turbulence should be an opportunity to purchase shares of a great business at a great price.

The last few years have presented several opportunities to purchase shares of valuable, great companies. While it’s dangerous to try to catch a falling knife—especially when it’s overpriced and cheaply made—catching the right knife can sharpen returns.

Take the “Dogs of the Dow” approach. By picking the 10 highest-yielding—and, by definition, cheapest, stocks—out of the 30 that make up the Dow Jones Industrial Average, investors have consistently outperformed the greater index by a long-term average of 3% per year.

In 2011, the dogs gained 17.2% (dividends included), 15 percentage points better than the broad market’s total return, or the 5% gain for the Dow as a whole.

Today’s seemingly worst stocks turn into tomorrow’s best, and today’s darlings become the spinsters of tomorrow. It’s a matter of time. Given the fickleness of the market, it is impossible to know whether it will take a month, year or several years for the value in a stock to be recognized. In any case, patience is a virtue.

For those interested in solid returns over the long term, be sure to invest in value. Your clients will thank you for it…eventually.