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Value Investing: What Buffett’s Admirers Get Wrong

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Every so often, I run into a value investor who thinks they are just like Warren Buffett.

Invariably, they quote famous sayings of his like, “Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”

Buffett did say that. It was in his 2008 letter to shareholders.

At the time, Buffett was making another fortune in the market crash. He had received favorable terms for investments in Goldman Sachs, Bank of America, GE, and other companies when they couldn’t find cash anywhere else.

While Buffett was buying marked-down, quality merchandise in the crisis, there was a hint of Don Corleone in the deals.

Buffett was asked for money. And, because no one else was lending, he made the companies offers they literally couldn’t refuse.

That’s an example of how Buffett’s everyman image is different from the reality. The people telling me about socks and stocks aren’t taking calls from CEOs of financial firms in a crisis.

The Problem With Value Investing

Still, despite the chasm between Buffett and us, the idea of value investing remains popular.

But stocks are not like socks. Stocks that are on sale could be cheap for a reason. If a stock drops by 50%, it could recover… or it could drop another 100%.

Value investors insist they do their homework and avoid stocks that are falling to zero. The alternative, they say, is to buy stocks that are going up and that’s even riskier.

However, that’s an idea that we can test.

We can define “value” in a number of ways. In one long-term test, value was defined with the price-to-book value.

In this same test, “momentum” was defined by how much a stock had gone up over the past year after excluding the last month. This is known as 12-1 momentum, a popular metric in academic research. I use a similar approach in my newest trading strategy, Market Leaders.

Data shows that in the long run, it pays to buy stocks that are going up rather than the ones going down. The chart below shows that momentum has outperformed value in the very long run.

(Click here to view larger image.)

The results show a dramatic outperformance by momentum. That’s especially true in the past 10 years. However, there have been times when value did outperform, such as from 1987 to 1998. The next chart shows that period.

(Click here to view larger image.)

Value had a strong run for nearly a decade. But a rapid burst of outperformance by momentum stocks erased the gap between the two in less than a year.

Get Better Returns With Momentum Strategies

Now, value has been profitable for decades. It has even been a market-beating strategy in many decades. However, the returns tend to pale in comparison to those attained with momentum strategies.

There’s a reason for this. Value stocks tend to be beaten-down companies that might or might not come back.

Momentum stocks are those that traders are buying. That buying pushes prices up and then attracts the attention of other momentum traders whose buying leads to further gains.

Momentum stocks are risky. But momentum traders don’t believe they should hold stocks forever.

In a nutshell, momentum traders buy stocks when they go up and sell when they go down. They may not even know what the company behind the stock does.

This is a different approach, but it’s one that has worked well in the long run, especially lately.

Traders who aren’t Warren Buffett — and that’s almost all of us — should at least consider trading these strategies.

Regards,

Michael Carr, CMT, CFTe
Editor, One Trade

Chart of the Day:
Is the Cannabis Downtrend Ending?

(Click here to view larger image.)

Cannabis has been a frustrating sector to invest in the past couple years.

Unlike the broad stock market, cannabis companies went almost nowhere but down last year. From its early 2021 peak, the ETFMG Alternative Harvest ETF (MJ) lost nearly 70% of its value. This is after spending 2019 in an even more brutal bear, and effectively going nowhere in 2020.

And this is despite the legal cannabis trend not only not slowing down, but accelerating. As Chris pointed out in his prediction piece, legal cannabis in the U.S. is just about a foregone conclusion. Major European powers are making moves, too. 

But price moves don’t necessarily correlate with real-world action. So, when can we expect cannabis to break its downtrend and start moving higher again?

To get an idea of this, I decided to look at this ETF with my new favorite trend indicator: Heikin Ashi candles.

To recap: downtrends in Heikin Ashi charts are defined as red candles with long bottom wicks and no top wicks. Trend changes occur when a candle appears with long top and bottom wicks, confirmed by a candle in the opposite direction.

Right now, MJ is printing its first such candle in quite some time. If the ETF sees some upside in the coming weeks, that would likely signal a new uptrend in cannabis stocks. I’ll keep an eye on this chart and let you know if I think that’s happening.

Regards,

Mike Merson
Managing Editor, True Options Masters

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