A popular trading maxim is that investors should buy what is cheap and sell what is dear. Relative value investing puts this principle into action. A relative value strategy involves examining similar instruments, buying what is cheap, selling what is expensive, and waiting for the valuations to converge. A simple yet elegant strategy, yet investors are best served to remember three key benefits and risks of relative value investing. The benefits are:
- Patience – With a relative value strategy, time is on your side. Well-executed trades are given time to work. Academic research has shown that value outperforms over long periods of time. Since we are buying the less expensive item, an imbedded value bias allows the benefit of this strategy to shine.
- Market neutral – By going long the cheap item and short the expensive one, we have taken no market risk. Regardless of what the average stock does, our concern is the relationship between the two items. This insulates us from wild swings in the value of the Dow Jones Industrial Average (Dow) and prevents such volatility from skewing our judgment and leading to inopportune decisions.
- Ease of research – Instead of diving into complicated company-specific research, you focus on the big picture. Stock-screening tools will allow you to narrow a search to specific industries, rank the companies from cheapest to most expensive, and then pick your target.
While the benefits of this strategy are clear, there are also risks we must consider. The three main risks are:
- Cheap for a reason – Comparing companies in the same industry, some may be cheap for a reason. Whether an outdated product line or unstable financial condition, the cheap companies may be sending a warning sign that investors should steer clear. Ignoring the warning and plowing ahead will result in large losses.
- Overvaluation – Relative value examines the differences in valuation, not the absolute level of valuation. In some markets, all items are overvalued and the proper approach would be to not buy any stocks. A recent example is the commodity bubble. During the summer of 2008, all commodity prices were at levels that eventually deflated. As most of the prices fell over 70% in a few months, the proper approach would have been to either short or avoid this sector, not to trade between the relative overvaluation of different items.
- Style drift – Looking to implement a trade, we must ensure that each item is well related. Trading Dell against Hewlett-Packard is clean. However, what if we trade Dell against IBM or Apple? As the companies become less similar, the framework of relative value breaks down.
Used properly, relative value investing can offer a simple, effective method of managing risk and improving return. However, the devil is always in the details. Before pursuing this strategy, investors should familiarize themselves with the risks and benefits. Well-informed investors will increase their chances of outperforming.
Sean Hannon, CFA, CFP is a professional fund manager.
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