We are happy to be posting Michael's first blog at 5i Research, inspired by the Investing Mistake series.  Michael has recently joined the team at 5i Research and you can expect to see a lot more from him going forward:

When considering the purchase of a security for its short term and medium term prospects, valuation tends to be a poor timing tool. When I opened my first discount brokerage account, I loaded up on cheap stocks with P/E ratios lower than their historical averages. To my surprise, the market did not reward this discount and in the coming months, the portfolio got “ cheaper”. What mattered most - and what I failed to do - was evaluate the existence a company-specific event that would improve the investor’s perception of future prospects. Without this centrepiece, there should be little reason to reward a cheap stock in the short run. Additionally, there are external factors that can have a far greater impact in the short term, such as general market psychology.

When evaluating the long-term investment prospects of a stock, valuation is extremely important. The ultimate return on investments will be determined based off the price paid today. A good valuation will also help decrease downside risk and provide a margin of safety. For the most part, we all set out with the best intentions when picking stocks for the core of our portfolios i.e taking a long term perspective as described above. The amount of discipline required to do this however, makes it extremely challenging. In addressing this issue, I look back to advice I received from one of my mentors. He told me to build and follow a middle of the road strategy: "buy stocks that benefit from rising profit estimates from analysts, while trading at a reasonable valuation. Over a two to three year time frame, the profit estimates will increase your chances of making money, while the reasonable valuation will decrease your downside risk."

Ultimately, if a stock appears too attractive, the chances for outperformance are reduced if you are not paying a reasonable price for it. While valuation such as the P/E ratio should never be your only criteria for purchasing a stock, a valuation-focus coupled with other tools can increase success. Just make sure you avoid using valuations improperly - comparing a stock’s valuation to it’s historical average without context. Over time, valuations go up and they go down in cycles. You can purchase a stock at a P/E of 13.0x and if the P/E trend is expansionary i.e. the trend is moving up, you will make money. On the flip side, you can purchase the same stock two years later at 13.0x but if the trend is compressing, you will lose money. Same P/E, different points in time, different results. The better way to use valuation is to compare a stock’s value to those in it’s peer group. After evaluating the business and other qualitative factors of a peer group, use valuation as a final tool to determine where the best value lies.