VALUE INVESTING
Minimise the Downside

By Stephen Bland (TMFPyad)
August 20, 1999

I finished last week by saying that I am odds player. By this I mean that I attempt to turn the odds against finding successful investments in my favour. The value investor seeks to find shares which offer the lowest possible downside risk whilst at the same time possessing strong upside growth potential. Minimising the downside is, in my view, the key factor which distinguishes value from other styles. In my variation of value, this comes first in the trawl through the market for likely shares. Only having found candidates which possess this strength, do I then begin to consider the upside.

Analysis of the upside is critical to finding good value shares. Without this a share may possess little downside risk, but it may stay there, continuing to possess little downside risk but staying flat, going nowhere for years. Not good enough. But I'll leave the upside analysis to later. I want to bore everyone first with the idea of limiting the risk of losing money.

The reason that limiting risk is so important to me is that I invest in only a few shares at a time, often only one or two. For value investors who go into a much larger number of holdings at a time, some relaxation of the security factors may be acceptable. This is after all an art, not a science. But I am concentrating on my particular approach at this stage. People can then think about it and add their own ideas as they see fit.

The idea is that if a share is already at a very low valuation in the investor's view, its chances of going even lower are limited. Not impossible, of course, but far more limited than a share which is already on a high rating. But note that the share is on a low valuation because for some reason it has been neglected by the market. Few people are interested in it. By becoming interested in such shares the value player is in consequence going against the market – what is known as the contrarian strategy. Doing the opposite of almost everyone else.

To specifics. My four fundamental and essential security features with which I test likely shares are as follows. I'll explain them in detail afterwards

P/E ratio

I start by looking for a maximum of two-thirds that of the market. Preferably much, much lower. For example, the current market P/E is in the twenties. Two-thirds gives me around 15–16 or so. That is still uncomfortably high for me. Single digit is much more attractive. Recent investments of mine have been on P/Es of between five and eight.

Yield

Preferably 50% above the market, which gives around 4% or so minimum at present.

Assets

I am an asset player. I want to buy the company for less than the net book value of its assets. So Price/Book Value under 1.

Debt

None is best, preferably with stacks of net cash.

These four basic features are ones I have been using for many years. They became known to me by the acronym pyad.

Some explanation of my reasoning:

The P/E ratio is the most widely used comparative measure of the value of a share. Other things being equal, a share on a ratio of seven is cheaper than one on a ratio of 30. Other things are unlikely to be equal, of course, but it shows the point. If the share is already rated on a low P/E, it is less likely to fall than a highly rated share, particularly if earnings expectations fall only slightly short. High P/E shares are frequently completely murdered for a tiny underperformance in earnings. Not so with low P/E ones; they are low rated already so nobody is expecting too much in any case.

Yield is the cash dividend income to be expected for holding the share. I want a bit of compensation while I am waiting for a value share to perform, comparable to money in the bank. Maybe it never will, which happens, but then at least I've had something out of it. And if it does perform then a good yield is a nice sweetener. High yield is an ancient and tested indicator of value and is used in many mechanical schemes such as our BTF and others. It helps to protect the share from falls because this will only drive the yield even higher, assuming the dividend is secure. A secure high yield is attractive to income investors.

Assets represent the hard facts of what I am getting for my money. Note that book value is not the same as market value, but it is something to go on. Few shares trade below book, particularly in high markets. Those that do are usually in difficulties, or there are certain special features that cause this. For example, property companies and investment trusts nearly always trade below book. But if you can find a trading company share that is not in difficulties, then P/BV under 1 puts a nice floor under the share price and as a bonus makes the share attractive to a bidder. A great security feature but quite rare at the moment.

Debt, in my view (and not everyone agrees), is a negative aspect of a value share. The more debt the company has, the more risk is present in buying the shares. Those who own the debt have to be paid their interest come what may. Compare this with net cash. There may be some debt but cash and near cash balances should exceed the debt. If the company has substantial cash balances, this again is a security feature. Not a lot of harm can come to it in such a case. And as an added bonus, just as with assets, a company with a lot of net cash is extremely attractive to a bidder. So no debt if possible is my rule.

Having shown the four features, they are not written in stone. I will be flexible in good cases, though very rarely on P/BV<1. But on yield, for example, I may not insist on a yield of 50% over the market if the other factors match up.

There are a few other security features to which I am attached. Market capitalisation must usually be over £100m. This is because I have found by hard experience that smaller caps are less reliable. There may be fewer brokers interested in publishing forecasts for example. Less institutions will be taking stakes in the shares. The directors in general will have less integrity in their comments on the company's prospects and so on. The smaller the company, the more this sort of thing applies, an inverse ratio. Consequently I introduced the cap filter in recent years to cut out the small cap effect. I found simply that too many smaller caps were going wrong. A larger cap value play can go wrong, of course, through a missed forecast etc., but it is less likely. Remember I am trying to turn the odds in my favour.

I might bend the cap rule a bit down to say £70m for an exceptional case but hardly ever lower.

Other downside damage limitation factors include relative weakness. Relative strength/weakness figures were unavailable to the private investor until pretty recently so I would do it intuitively, comparing the share price of something in which I was interested with the market movement over a year which was in my head. But since it is now available I look at the one year RS figures and am cheered up by a decent negative showing – relative weakness. I don't place crucial importance on this, it's just one of those little comfort factors that help if everything else adds up. Value players are contrarians. We don't want shares that everyone else has been buying, we want that which they have been dumping – unreasonably of course in our view. We want the market lined up against us. Because that means the price of the share will have been driven down to what we hope are absurdly low levels. Negative RS suggests that this has been happening.

I know people set great store by positive RS, and of course at the Fool we have RS-based mechanical schemes. So it might seem odd to some that I seek the opposite. But in the context of value shares it makes sense, as I've shown above. However as I say it's not one of my fundamental factors.

Other less important security features include negative press and broker comment. Like negative RS, they are all signs that the shares are being dumped and will drive down the price. In most cases they deserve this treatment but remember we are looking for those that don't deserve it. Again, though, this is not a critical factor.

So that's it for this week on minimising the downside. The first step. Shares passing these filters will be far less likely to fall than average or highly rated shares in a bear market. I have no interest whatsoever in losing money, in fact I am close to being clinically obsessed with not doing so. I can never understand the approach of many other investors who show not the slightest interest in considering the downside risk of their investments.

Next week it's the turn of the upside. We've found our shares with the risk as low as possible. Now we want to make some serious money out of them. But why should they go up when everyone else has been getting rid of them?

Post your questions and comments to the Value Shares board.