As an investor, it’s natural to be attracted to stocks that seem undervalued and present an opportunity for significant gains. Value investing, a strategy focused on identifying stocks that are trading below their intrinsic value, has gained popularity among many investors. However, it’s important to recognize the potential pitfalls of this approach and the importance of having an exit plan.
One prominent example of the challenges faced by value investors is Alibaba Group, a Chinese conglomerate that has seen a significant decline in its stock price since 2020. With the stock dropping from a high of around 315 to nearly 75, investors who saw great value in Alibaba’s price have experienced substantial losses. Even those who entered at 120 have lost almost half of their capital over the past two years.
While some investors believe that value stocks present an opportunity for profitable investments, it’s essential to consider the long periods of waiting and missed opportunities in other stocks that come with this strategy. As the world over has witnessed other stocks rallying, investors stuck in a value stock like Alibaba have not only missed out on potential gains but also endured significant capital depreciation.
When considering value investing, it’s crucial to examine your investment thesis and whether it aligns with your goals and risk tolerance. If your objective is to pick value stocks, Alibaba may appear to be a deep value opportunity. However, one must consider the psychological impact of enduring extended periods of drawdowns, waiting for a potential recovery.
Investing in IPOs also exemplifies the challenges of value investing. Investors who bought into an IPO in 2014 may still be waiting for any return on their investment, having endured a decade-long waiting period. It’s important to question whether you’re comfortable with such extended periods of drawdowns and uncertainty, as there is no certainty that a value stock will eventually rise.
Moreover, holding onto a value stock without an exit plan can be extremely dangerous. It leaves investors vulnerable to the irrational and prolonged fall of a stock, potentially leading to significant losses. Unexpected factors, such as political decisions or market shifts, can impact the perceived value of a stock. For instance, if the former US President, Donald Trump, were to take actions that negatively affect Chinese companies operating in the US, a stock like Alibaba could plummet further, leaving investors in a precarious situation.
When engaging in value investing, it’s crucial to have an exit plan. Setting clear parameters for taking profits or reevaluating your investment can help mitigate risk and protect against irrational market movements. Establishing exit points such as selling 20% or 30% above your purchase price allows you to secure gains and reassess the stock’s value.
In contrast, momentum investing takes a different approach that can potentially reduce some of the risks associated with value investing. By focusing on stocks that are already showing positive price momentum, investors can board the metaphorical bus that is already in motion. This strategy allows investors to capture upward trends in stocks and avoid getting stuck in prolonged drawdowns.
Ultimately, the goal of investing is to make money rather than proving market inefficiencies or proving who is right or wrong. Value investors must consider their motivations and question whether their insistence on finding value comes at the cost of missed opportunities and prolonged periods of capital depreciation
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