VALUE INVESTING
What is Value?

By Stephen Bland (TMFPyad)
August 13, 1999

Before starting, I would like to thank the Investors Chronicle for the kind permission they gave me to use extracts from their company results pages for the purposes of illustrating various specific shares for my series.

First of all, I would like to say that I am aiming this series at readers who already understand basic investment analysis, in the sense of all the commonly used ratios and so on. I don't propose explaining what these are here. So if anyone is interested in coming on this journey and doesn't know much about that stuff, I recommend they do a bit of homework first on the fundamentals. Only simple stuff mind, there is no complex mathematics or arcane accountancy knowledge required. This is not (I hope!) because I am too arrogant to explain this to readers, but because I want to concentrate on the subject itself.

Keep It Simple, Stupid! is very much a feature of the value approach and I am deeply suspicious of anything excessively complicated which claims to make money in the markets. Especially where it involves projections years into the future or complex formulas to data mine patterns in the past for mechanical schemes. KISS works, over-analysing complexity rarely so in my experience.

I need to put forward a definition of value shares before I launch into my stuff about what this means in practice, so that everyone knows what I am talking about. People love to pigeonhole things, it makes them easier to discuss by bringing together those that follow a particular subset of items under one heading. Music, for example, is categorised as classical and popular. Within these will be many subcategories such that popular includes jazz, pop, metal and so on. Thus, by using these convenient descriptions, people can identify others with similar interests, rather than just music fans in general. The problem with pigeonholing, though, is overlap.

With shares you often hear about growth or value types of share or investor. But everyone who buys shares seeks growth, so aren't we all growth investors? In one sense, yes. But in the pigeonhole sense, then no.

All shares will have certain fundamental ratios and facts about them that can be analysed for the purposes of comparison with other shares as an investment. It is in the varying emphasis placed on specific groups of those ratios and facts by certain investors that the essential difference between growth and value investing lies. And as with music, there is a substantial area of overlap where mixed views prevail, drawing on what are perceived as the best features of both growth and value strategies

Value shares can be hard to define. And views will vary amongst people; there is no official or definitive version. Bruce has said for example with the Qualiport that he seeks good value. But he will agree with me, I think, that this is not the same thing at all as what I define as value. And again, many people will have a different concept to me as to what constitutes value. Rather than put across my personal interpretation of what constitutes a value share, at this stage I will try to give my opinion of what I see as a general idea of the concept. Here goes then

"A value share is one that is selling unreasonably cheaper than other shares of a peer group, on the basis of some investment criteria."

This needs a little expansion.

The peer group. Fairly easy, that will usually be the market, indicated perhaps by the FTSE All-Share or maybe the FTSE 100 index. It could often be a sector as well.

The investment criteria. Again easy, these will usually be the well known and simple ratios such as Earnings Per Share, Price/Sales, Price/Earnings, Yield, Price/Book Value, Gearing and so on. There are quite a few of these ratios and data facts and it is critical that any value investor understands them fully. For shorthand I will refer to these items collectively by the usual description of the "fundamentals."

And finally in the definition the hardest bit. "Unreasonably". What does that mean? In the answer to that question lies the very concept of value itself. Crack that one and you're there. But the idea with this is that the share is believed by the observer to be selling at a level much lower than it ought to, as a result of an analysis of its fundamentals and comparison of those fundamentals with a peer group. Put simply, you think the market has got it wrong and the share should trade at a much higher price.

It is interesting to ask why there may be shares that are unreasonably undervalued. After all, the stock market is a pretty efficient place in my view and information is disseminated very rapidly, especially these days with electronic media. Many people, Efficient Market Hypothesis believers, think that there are no such anomalies, that all valuations are reasonable because the information is public and therefore is included in the price. It is thought by followers of this idea that any way of identifying shares that appear to be undervalued involves extra risks over and above the market generally. So if anyone beats the market, the explanation is that they can do so only by taking those extra risks. By increasing the risk/reward ratio. So you might as well just buy the whole market via a tracker fund and forget about it.

I do not accept this argument. I hope to show people that value share investing can be one of the lowest risk approaches to individual share buying that exist, whilst at the same time providing outstanding returns. This might sound like alchemy, the turning of lead into gold. Traditionally high returns go hand in hand with high risk. We all know the stories of people buying shares like Microsoft etc. for a tiny fraction of their current values and making fortunes. But the risks in finding a share like this are staggering. Because anyone who follows markets knows well that for every Microsoft at its infant stage there are a huge number similar shares that are complete failures. You can see this now with internet plays.

So how do you know which is the right one? You don't. You take huge risks, either on finding the right one by chance, or by investing in a very wide portfolio of such shares, hoping that one might make it, pay for your losses and make some money.

High risk investing. The small chance of high rewards. The much higher chance still of losing your money. Thanks, but no thanks.

Value, I believe, should aim firstly to cut out as much of the risk as possible. That is the first hurdle to success at this game. Minimise the downside, then maximise the upside. Ask not how much you'll make out of a share, at first, but ask how much it might go down if you are wrong. All share buying involves risk, of course. But I am an odds player; I want to turn the odds in my favour as much as I can. That is what the next article will discuss.

Please post any comments or questions on this new feature to the Value Shares board.