Any person interested in the financial market has information on who Warren Buffet is. To many, Warren is the best value investor of all time (and even day traders can borrow some powerful lessons from him).
His story has been written and rewritten many times. How he has managed to build a multibillion dollar company consistently over the years has been amazing.
On the other hand, there is James Simmons who runs a trading hedge fund. Renaissance Technologies has had an excellent track record. It has done extremely well during times when the market is bearish. In 2008, the company made more than 80%.
These two are the best examples of how different the financial market is.
On one hand, we have a trader who has achieved great success and on the other hand we have a value investor who has been very successful.
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What is value investing
Value investing is a process of allocating money in companies that you believe are severely undervalued and those you expect will bounce back in the future.
Value investors look at several factors in determining whether companies are undervalued or not. For example, they compare their earnings, EBITDA, and sales multiples with their peer companies.
A company that has a PE multiple of 10 is said to be undervalued compared to a similar company that has a PE of 20. Therefore, a value investor can attempt to understand the discrepancy in valuation and then invest if they believe that the company is being mispriced by investors.
Another popular approach is to consider a company's cash flow to determine whether it is a good investment or not. Investors use a discounted cash flow (DCF) approach to find companies that are undervalued.
The opposite of value investing is growth investing. Growth investing is a process where an investor buys companies that are showing strong growth momentum.
At times, most of these companies tend to be highly unprofitable. Examples of popular growth stocks are firms like Roku, SentinelOne, and Affirm
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How day trading works
Day trading is significantly different from value investing. It involves analyzing charts and then opening short-term trades. The rule is that a day trader should not leave a trade open overnight.
Day traders do not focus on the overall fundamentals of a financial asset. For example, they don’t care about whether a company is profitable or not. Instead, they only focus on how the asset’s chart is moving. In fact, most traders focus on companies that don’t have solid fundamentals.
Day traders base their positions on technical analysis, which involves the use of technical indicators like moving averages and the Relative Strength Index (RSI). They also focus on chart patterns like triangles and head and shoulders patterns.
Stocks good for trading
Many big companies like Aon, Berkshire Hathaway, and Humana are usually good for investments but not for trading. For one, a stock like that of Berkshire goes for over $500k, making it out of reach for many day traders. Stocks that are good for trading have several characteristics:
- Highly liquid - These stocks should have adequate volume, which means that one should be comfortable buying and selling.
- Volatile - Ideally, you should focus on companies that are highly volatile. You will find market opportunities amid this volatility.
- Hype - In most cases, you should trade stocks that have hype among traders and investors. For example, trading companies like GameStop and AMC during the meme stock mania was a very profitable strategy.
Why value investing lose against day trading
#1 - Challenge of Finding Value
The first reason We prefer being a trader is that finding value these days is one of the most difficult things to do. Finding a good company to invest in is really difficult especially today when companies are expensive.
For instance, a company such as Tesla Motors which is just a few years old is valued at more than $900 billion. On the other hand, a company as Ford that is more than 100 years old is valued at $50 billion.
Remember, value investor aims to buy a company cheaply and then wait for it to gain in value. This is the main reason why hedge fund managers have failed to achieve alpha some times ago.
As a day trader, we are not focused on the fundamentals of a company. Instead, we are just aiming to make money when a company follows a certain trend.
#2 - Difficulties in Projections
As a value investor, you must be excellent in company valuation. You must be good at understanding when a company is over or undervalued.
The challenge is that projecting the future value of a company is very difficult. For instance, some years ago, shale was the top sector which investors were flocking to. Investors put in billions of dollars.
However, as oil supply increased, the investors lost money because of falling oil prices. Today, many shale producers have gone bankrupt.
For a trader however, it was easy to make money during this period by shorting the shale producers.
Another example is in the communication space. In the past, Nokia was the leading device maker. No one ever predicted a time when Nokia would be dethroned. Today, Nokia’s mobile division is no more and investors who put in money have suffered huge losses.
Most recently, a good example is a company like Meta Platforms, which was previously known as Facebook. For a long time, the company was a favorite among investors. It also became one of the few members of the FAANG stocks.
This strength happened because of the company’s strong market share in digital advertising. It had a strong moat in the industry and was difficult to disrupt. However, in 2022, its stock crashed as competition with TikTok rose.
It was also hard for investors to predict the impact of Apple's IoS update that introduced more privacy features.
#3 - Stake in the Company
To be as successful as Warren Buffet is, it is important to have a say in the running of the company. As an investor, you can buy shares in a company and assume the top management will do a good job or buy shares and have a say in the running of the business.
Furthermore, as a shareholder, you own a part of the company. Right? No. You only have a say when you have a valuable stake in the business.
To do this, you need to invest millions of dollars in the company. For a trader, you don’t need to have any large stake in the company. You only need to identify a trend or a news update, enter the trade, and leave when your thesis is proven right.
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#4 - Automating Trading
For value investing, you need to do intense research on a certain company. This research will involve looking at a company’s books, management, projections, and competitors. After doing this, you can invest in the company if it meets your criteria.
On the other hand, in day trading, you can easily automate your trades by creating algorithms. After you create and backtest your algorithms, they will be trading for you. Alternatively, they will be sending alerts to you if a certain instrument matches the criteria.
Therefore, in automatic trading, your task is to monitor the performance of the instrument and then make corrections when necessary.
#5 - Multi-direction
An important thing about the stock market is that assets don't always move in a straight line. For example, stocks rallied sharply in 2020 and 2021 as the Federal Reserve embraced an extremely expansive monetary policy.
At the time, most indices like the Dow Jones and the Nasdaq 100 rose to an all-time high. Here, people who had invested in the market made a lot of money.
However, in 2022, stocks crashed hard as the Fed started tightening. Therefore, in this period, many people who had invested heavily in stocks lost a lot of money.
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On the other hand, traders were able to make money during the bull market of 2020 and 2021 and the sell-off that emerged in 2022. Therefore, traders are able to make money regardless of the overall direction of the market.
These are just some reasons why be a trader (in this case 'day trader') is better than be a value investor.
However, the best solution also depends on your attitude since all-day trading requires resilience to sudden changes and asks us to reckon with losses more often.
Value Investor Versus Trader - Useful Links
- Trading Vs. Investing: Which Is Better For Long-Term Goals? - Forbes