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Kelly Evans: How to become a value investor

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CNBC's Kelly Evans
CNBC

I loved Scott Wapner's interview of Andrew Wellington yesterday, in which Wellington addressed a few of the most common misconceptions about "value" investing and diversification.  

Value stocks are two very different things to two very different audiences. To the general trading community, "value" is just a synonym for "cheap." It's a mechanical definition, in which stocks that are trading, say, for less than twelve times forward earnings automatically get tagged in "value" indexes and portfolios, until they don't. When we talk about how much "momentum" has outperformed "value" this year, it means that strong performers with a high multiple (i.e. Zoom) keep rising, and cheap decliners keep selling off. That kind of thing.   

But value investing is very different. It's the opposite of chasing such trading trends. It's what Warren Buffett built Berkshire Hathaway upon; it's buy-and-hold stocks or companies that you can scoop up when "Mr. Market" is offering them at less than intrinsic value. How do you know their intrinsic value? That is the super hard part. Is Intel a value because it's trading at just eleven times expected earnings? Not necessarily. Are Adobe and Microsoft value stocks? Well, ValueAct correctly thought "yes" a decade ago and made billions as a result.  

The overlap is that a lot of value investors use screens to find cheap "value" stocks that they may or may not choose to invest in. Wellington, whose firm Lyrical Asset Management typically only makes five trades a year, is one such example. They start with the lowest multiple stocks, but they don't end there. "Our first reaction to looking at that list is, My God, what a pile of junk," Wellington said. "Most stocks are cheap for a reason. [But] if you sift through them carefully...[you can find] a bunch of gems. That's our approach."  

Lyrical uses proprietary estimates of five-year forward earnings to figure out which stocks are potential gems. Again, having good forward estimates--i.e., predictions of the future--is the hardest part. "We couldn't build a fifty stock or a one-hundred stock portfolio, but we can build a thirty-stock portfolio" this way, Wellington said. His current holdings include Whirlpool and Ameriprise Financial.  

But wait, people say, if you only own 30 stocks, you're too highly concentrated! And that's where the other major misconception about investing comes up. 

A lot of folks seem to think these days, because of the rise of passive index investing, that you're not safely diversified unless you own at least the S&P 500--even better, the Wilshire 5000. But one thing I learned in my CFA Level 1 reading was that as far as the research is concerned, you're diversified before you even hit 30 stocks. I still remember exclaiming to my husband, "The Dow makes sense!"  

People love to hate on the Dow Jones Industrial Average because it's 30 "arbitrary" names and the S&P 500 is what the real investors watch. I don't buy it. In fact, the essential sameness of the performance of the Dow versus the S&P over time confirms that you can be fully diversified by owning just about 30 names.  

Anyhow, Wellington echoed this point. "If you own thirty different stocks in a portfolio, you're getting almost all the benefits you would get from a much larger portfolio of a hundred or more stocks," he said. Point being: his stock-picking strategy is no riskier because it's "concentrated" to only 30 names.  

In fact, you could even try it at home. Not so much the way the pros do, by trying to start with the correct super-cheap stocks that will generate huge outperformance over time. That's too hard. But you could try building your own version of the Dow from quality names you like in each sector of the market. The trick is to have a very long time horizon--decades, if possible--and to change the names only infrequently, and with good reason.  

Call it the "Family 30." Your index committee could meet every Christmas. You might be surprised how well you stack up against the major averages over time. If nothing else, it's a great way to teach kids about investing, and not a bad way to diversify away from the S&P 500 if you ever worry about index fund distortions (cough cough...Tesla).  

See you at 1 p.m! 

Kelly

Twitter: @KellyCNBC

Instagram: @realkellyevans