How do value investors rationally own stock? According to their methodology, each stock can be valued at a certain price. As an example, let's say stock X is trading at $100, and a value investor comes up with fair value at $80. At what point is it rational to buy? Surely at $79.99 it is now "value" and should be bought, rather than holding cash or index investments? I do not see how it can be rational to wait for lower prices - if the stock is cheaper than the alternatives, a value investor is compelled by their methodology to own it. There now arises the problem - if fair value is $80, how can the investor hold it above $80? Logically the investor is compelled to sell at $80.01.
Graham and Dodd tried to come up with a rationale for waiting for bigger discounts to true value. Due to risk, uncertainty, illiquidity etc, they said an investor should wait for a margin of safety of 50%. However, they then have the same problem, it's just that the price is different. In the case of stock X, their margin of safety would put a buy point at $40 - half the intrinsic value. So they buy at a huge discount. The problem is, as soon as it goes back to $40.01 or higher, they again have to sell to be logically consistent. If a 50% margin of safety is required to own the stock, then that means 49.99% is not enough. If they would not buy at $40.01 on the way down, then how can they own stock at $40.01 on the way up? Assuming the intrinsic value does not change, the rational value investor can only take 1-2 ticks out of any investment.
To hold on for longer than two ticks, the calculated intrinsic value must increase each day by more than the stock price appreciation - a rather far-fetched assumption.
Note that growth stock investors do not have this problem as much, because they are typically buying and holding stocks that are going up to new highs. However, it faces ALL dip-buying investors who do not claim to be able to predict future price. How can you not own something at price X, buy at X minus 1, then hold at X +1? If it is cheap at X+1, then you should have bought at X+1 or X on the way down, shouldn't you?
Can someone point out the flaw in my logic? Or is all valuation-based investing completely irrational?
Traders do not face this problem, because they are saying "price is headed higher". Yet almost all investors claim they can't predict price, only valuation. Yet they willingly refuse to own stock when it is undervalued, then after purchase, they hold it when it is at a higher price than before when they refused to own it. Makes no sense to me.
A secondary paradox comes after exit. If you sell a stock at $100, that means you thought it was a buy at $99.99. But if you think that, then doesn't it become a buy again at $99.99 if it falls back a tick? Thus, all value investors should re-enter their positions as soon as they fall 1 cent.
N.B. all this assumes no minute by minute change in the valuation. Obviously sometimes news comes out which causes a large shift in value, and then selling and not re-entering makes sense, as does buying and not immediately selling 1-2 cents higher.
Graham and Dodd tried to come up with a rationale for waiting for bigger discounts to true value. Due to risk, uncertainty, illiquidity etc, they said an investor should wait for a margin of safety of 50%. However, they then have the same problem, it's just that the price is different. In the case of stock X, their margin of safety would put a buy point at $40 - half the intrinsic value. So they buy at a huge discount. The problem is, as soon as it goes back to $40.01 or higher, they again have to sell to be logically consistent. If a 50% margin of safety is required to own the stock, then that means 49.99% is not enough. If they would not buy at $40.01 on the way down, then how can they own stock at $40.01 on the way up? Assuming the intrinsic value does not change, the rational value investor can only take 1-2 ticks out of any investment.
To hold on for longer than two ticks, the calculated intrinsic value must increase each day by more than the stock price appreciation - a rather far-fetched assumption.
Note that growth stock investors do not have this problem as much, because they are typically buying and holding stocks that are going up to new highs. However, it faces ALL dip-buying investors who do not claim to be able to predict future price. How can you not own something at price X, buy at X minus 1, then hold at X +1? If it is cheap at X+1, then you should have bought at X+1 or X on the way down, shouldn't you?
Can someone point out the flaw in my logic? Or is all valuation-based investing completely irrational?
Traders do not face this problem, because they are saying "price is headed higher". Yet almost all investors claim they can't predict price, only valuation. Yet they willingly refuse to own stock when it is undervalued, then after purchase, they hold it when it is at a higher price than before when they refused to own it. Makes no sense to me.
A secondary paradox comes after exit. If you sell a stock at $100, that means you thought it was a buy at $99.99. But if you think that, then doesn't it become a buy again at $99.99 if it falls back a tick? Thus, all value investors should re-enter their positions as soon as they fall 1 cent.
N.B. all this assumes no minute by minute change in the valuation. Obviously sometimes news comes out which causes a large shift in value, and then selling and not re-entering makes sense, as does buying and not immediately selling 1-2 cents higher.