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Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.

Mark LaMonica: All right. So, Shani, in the podcast app that we use – so this is actually what we uploaded into and then it gets distributed, I guess, to multiple podcast apps. And they give you stats about different things. And one of the things they do is they have this giant world map, and they show you how many listens you've got in every single country. And I counted the countries where we have never had a listen.

Jayamanne: Okay.

LaMonica: And there are 29 of them. Now, most of the ones that we've missed are in Africa. We're not doing great in the Stans.

Jayamanne: No.

LaMonica: Not doing great there. No listens in Greenland, none in North Korea.

Jayamanne: Surprising.

LaMonica: Surprising, exactly. So, yeah, I think that's pretty good, though.

Jayamanne: I think we're doing pretty well.

LaMonica: Yeah, all the countries in the world, only 29 we haven't had a listen in.

Jayamanne: It is disproportionately weighted towards Australia and the US. And the US would just be your mother, repeatedly listening to the episode.

LaMonica: And I don't know why she is not building a bigger audience, sharing this with her friends.

Jayamanne: Maybe she should go to Africa.

LaMonica: Maybe she should. Better there than Australia, right?

Jayamanne: But we're going to do a competition.

LaMonica: Exactly.

Jayamanne: Because we want to knock as many of these off our list as possible.

LaMonica: And knowing some, like, we're probably not going to get North Korea.

Jayamanne: Maybe. We'll see.

LaMonica: Yeah, you never know. You never know. Last time I was in South Korea, I went to the DMZ. So, I was pretty close.

Jayamanne: You should have just chucked your phone over the border.

LaMonica: I guess that would be one approach. I don't really know how the North Korean border guards feel about people throwing things into their country. But yeah, we'll see. Maybe that was a lost opportunity.

Jayamanne: Yes. But let's talk about the competition.

LaMonica: Okay.

Jayamanne: So, the competition is if you have a friend or family or anybody that you know.

LaMonica: Or you want to visit.

Jayamanne: Or you want to visit one of these countries, which we're going to put in the episode notes, and you can show us that you got in touch with your friend, they went and listened to it, and we see that it's clocked over on our podcast servicing app, we will give you a prize.

LaMonica: That sounds like a good competition.

Jayamanne: Yes.

LaMonica: You do need a prize. And Shani is going to list the 29 countries.

Jayamanne: I'm not going to do that.

LaMonica: In the episode notes. Not now.

Jayamanne: Yes.

LaMonica: Not now. In the episode notes.

Jayamanne: Yes. So, what is the prize you may ask, because that's important to this. The prize is that we always talk about the Warren Buffett drinking game.

LaMonica: We do. Not as much lately.

Jayamanne: No. No. We haven't talked about him that often. But we will give you a gift card or a voucher to your chosen bar somewhere near you to go and play the Warren Buffett drinking game. And if you do not drink, we'll send you some tea.

LaMonica: Okay. That sounds fair.

Jayamanne: Yeah. So, if you'd like to participate, everything is in the show notes, but you can send it through to Mark's email address.

LaMonica: Which is also in the episode notes.

Jayamanne: Yes. All right. Let's get to the episode. This is getting very complicated.

LaMonica: Okay. I know everyone is probably sick of that long-winded explanation about our competition. But the question is, do you think that everyone is sick of us talking and saying – talking about and saying that valuation matters?

Jayamanne: Well, we're just going to keep saying it, Mark.

LaMonica: Yeah. Well, I guess fair enough. But today, we're going to talk about a recent piece of research that once again shows that valuation matters. So, Morningstar looked back at our fair value estimates to determine what impact they had on returns. So, in this particular study, we used our US coverage list, which includes almost 700 companies, and we explored data over a 21-year time period, starting in 2002.

Jayamanne: And we aggregated the individual fair value estimates for each share and weighted them by market capitalization, which is how major indexes like the S&P 500 and ASX 200 are constructed. This provides a fair value estimate for the US market. Comparing the aggregated fair value estimates and prices allows us to determine if the market is overvalued, undervalued, or fairly valued.

LaMonica: And then what we did is we tracked the return over a three-year period for each monthly fair value estimate. So, guess what? Returns were higher when the market was deemed to be undervalued than when it was overvalued. And the outperformance was 0.76% a year. And this may not seem like a lot, but it is significant over a long holding period, investing $1,000 a month for 30 years and earning a 7% return results in $1.169 million. Earning a 7.76% return yields $1.346 million.

Jayamanne: So that means you should own shares when the market is undervalued and sell them when the market is overvalued.

LaMonica: And that, Shani, is called market timing. But I always thought that market timing was a bad thing.

Jayamanne: And we keep saying time in the market is better than timing the market.

LaMonica: And that is what we always hear. So, if that is true, then what should we do with this data?

Jayamanne: I think we need to dive a little bit more into the research.

LaMonica: We do. And as Paul Harvey would say, Shani, we need The Rest of the Story.

Jayamanne: Who is Paul Harvey?

LaMonica: He is a radio host. So, he was a radio host in the US.

Jayamanne: Do you think many of our Australian listeners – most of the people listening to this are an Australian, Mark?

LaMonica: And hopefully one is going to be in Turkmenistan, one of the countries that we need. But yeah, I don't know. He was a radio host in the US. He started in the 70s and he had this radio show, and it was called The Rest of the Story. So obscure fact, I guess. She is looking at me like I'm crazy.

But anyway, purchasing cheap shares and selling expensive ones works better than the alternative. That is the rest of the story. That's what we need to look at. The alternative, of course, is that we can compare that approach to an investor that simply bought shares at the beginning of the period and held them. So, have you recovered your power of speech, Shani, after that death stare you were giving me when I was talking about Paul Harvey enough to talk about what we found when we made this comparison?

Jayamanne: I guess I have, Mark. But unsurprisingly, buy and hold outperforms a portfolio that is trying to time the market using valuation as an input into buy and sell decisions. In this analysis, we tried to make it realistic and assumed an investor had additional cash to invest over the 21-year period.

LaMonica: Right. And what gets lost – this is another thing we hear all the time – and what gets lost in many of this lump sum versus dollar cost averaging debate is that most investors don't really have a choice. Many of us save money each time we get paid and invest regularly. We don't start out with a lump sum that we can either invest in totality or parcel out over time.

Jayamanne: We ran a model that assumed that contributions were made into a portfolio on a monthly basis. In the buy and hold scenario, the money was invested as soon as it was available. In the market timing scenario, the money would only be invested if shares were undervalued. If the market was overvalued, the cash would be retained until a time when the market was cheap again.

LaMonica: So, over that time period, the buy and hold strategy outperformed market timing by 10% cumulatively or just less than 1% a year.

Jayamanne: What held back the valuation-based market timing strategy? Cash drag. Though the strategy earned higher average returns when the equity screens indicated the market was undervalued, it was more than offset by the upside the strategy missed out on when those same signals showed the market was rich.

LaMonica: In other words, because stocks tend to go up over long time periods, it pays to be fully invested, even if occasionally going to cash might have taken some of the edge off. It is also worth noting that taxes and transaction costs were not included in this analysis. That would have eroded the return further.

Jayamanne: Okay. So, what should we do with this information as investors? That's a million-dollar question.

LaMonica: And once again, Shani, as Paul Harvey would say, the rest of the story.

Jayamanne: Okay. So, a buy and hold strategy led to higher returns. A prudent strategy may be to combine the two, regularly invest but direct those investments to undervalued assets.

LaMonica: A simple example would be an investor with a portfolio made up of Aussie and US shares. If US shares were cheaper than Aussie shares, monthly contributions would go into the US. If the inverse were true a month later, the next contribution would be directed into Aussie shares.

Jayamanne: And that's easier said than done. By aggregating all of our analysts' fair value estimates on individual shares, we've essentially created an index. Selecting individual shares adds another element to this exercise. The individual share selected would have to replicate the results of the aggregation of all of our analysts' ratings. In other words, you need to pick the right share, something that a large proportion of value investors fail to do.

LaMonica: If multiple indexes were available to an investor, which of course they are, an assessment would just have to be made on which index to choose for each contribution. This is also a challenging endeavor. And it's important to note that our analysts' fair value estimates are based on a discounted cash flow or DCF analysis of a share. They are not using the relative valuation measures like a price to earnings ratio that are used by indexes that track value and growth strategies. A share with a P/E of 30 can be undervalued and one with a P/E of 10 can be overvalued using that discounted cash flow analysis.

Jayamanne: At the very least, this should give investors something to think about. Some investors have no interest in trying to determine the cheapest areas to direct their funds. Picking a single index and taking a buy and hold strategy may be the best approach for this group. Some investors will spend time thinking about how to implement a strategy that combines the best of both findings. All investors should appreciate that an investing maxim isn't as straightforward as it seems.

LaMonica: And if you want to spend time thinking about this and the approach of being fully invested versus timing the market, undervalued versus overvalued shares, you can ponder it on a flight to one of the 29 countries where you will listen to our podcast. And we do think you actually have to go there or find a friend, right? We don't want somebody using a VPN. So, I think that's an important rule when you're…

Jayamanne: In the spirit of the game.

LaMonica: In the spirit of the game. We do trust you, but trust but verify, Shani.

Jayamanne: Yeah.

LaMonica: All right. Thank you very much for listening. We really appreciate it. And of course, we would love any comments you want to put into your podcast apps or of course, email me. My email address is in the show notes.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)