VALUE INVESTING
Maximise the Upside

By Stephen Bland (TMFPyad)
August 27, 1999

Last week I wrote of the approach that minimises the risks inherent in buying value shares. Summing up this approach, it requires that cheap fundamentals be sought out as the first step to identifying likely value candidates. Value investors will decide individually which particular fundamentals to go for, and levels of the ratios deemed to be acceptable.

My particular style takes a rather extreme view, you could call it deep or super value, by insisting on absolute bargain basement ratios; so low, in fact, that often there are no shares that qualify. That suits me because I need only a handful of shares a year. They will be so cheap that my downside will have been minimised to the maximum. Because I invest in only a very small number of shares at a time, often only one, I have to insist on minimum risk. Others, who go into several shares at a time with less strict criteria than I do, may be willing to lower their value morals somewhat, because they have spread their risks.

Okay, we have identified a list of shares that satisfy the requirements of the cheapest fundamentals. Are they all going to be great value plays? Almost certainly not, is the answer here. Many shares have cheap fundamentals because they deserve them. That is, they are not undervalued at all but are actually correctly valued. The fundamentals, upon further investigation, turn out not to be cheap at all, when the actual reasons for them are discovered. Typically this is often a history of years of flat or declining earnings per share. The starting list will therefore very likely contain shares that will be of little interest, despite appearing, superficially, to be attractive. How to weed out the poor ones is the topic of this article.

A share whose fundamentals appear cheap, whose share price appears to have been undervalued by the market, must have some additional reason for it to go up, to realise or unlock the value. The key to that particular door is rising earnings per share. I cannot overemphasise the critical importance of rising EPS to successful value investing. Without this the shares may stagger along for years, going nowhere because there is little reason or incentive for anyone to buy them. All right, you'll still have the good yield – one of my fundamentals, remember – but the shares are being bought to make large profits for us, not mere income, valuable though that is.

One small aside at this point. Value shares are often takeover targets. The reasons are fairly obvious I think. The same ones that attracted the investor to them in the first place frequently interest a bidder as well. Undervalued assets, plenty of cash, low P/E, no debt, a fundamentally good business. These attributes are extremely attractive to predatory companies, as they are to us. But a warning. Never buy a share merely because you feel it has bid potential. I do not regard that as maximising the upside. If it comes, fine, it's the icing on a great value cake. But don't rely on it as reason to buy the shares, stick to rising EPS as the upside maximising factor; bid prospects come with the value territory anyway, as I mentioned.

In most cases brokers will publish earnings per share forecasts for the next year or two. Various sources will make this available to the public. It is absolutely essential that value shares possess strong, rising EPS figures. Try to find at least a 20% increase over the last actual figures from the company. Preferably more, so that you leave a little in case it goes slightly wrong. You won't find it very often with value shares.

The more brokers that publish forecasts the better, because it improves the chances of accuracy. However, exercise a healthy scepticism and never take broker forecasts for granted or attribute excessive accuracy to them. Forecasts have a nasty habit of not being met and the general record of analysts in this regard is not too good. Look only one year ahead; anything further is of little use because there are too many uncertainties.

One tip is where there are several brokers making forecasts, instead of taking the consensus EPS, which everyone else does, take the lowest one. If it still shows a rise of 20% or so over the latest actual figure then you have built in a margin of error.

Pay great attention to directors' comments for forecasting. I find these to be a very good source of indicators as to the likelihood of rising profits or the reverse. Directors are often rather cagey, understandably reluctant to commit themselves too much in case they are shown to be wrong by the eventual facts. Few like to look a fool in this way. Incidentally, this is one reason I prefer value shares with a market cap over £100m. Directors of such companies, in general, possess more integrity and are less likely to make comments they know to be inaccurate. Not so with tiny caps and AIM companies, where there tends to be a lot more hype and less substance.

Study lots of directors' reports to familiarise yourself with the language of directorese. Try to learn reading between the lines. An interim report may say, for example: "Profits for the year are unlikely to be less than last year." This is quite positive, in fact, suggesting a decent rise is on the way. Compare this with the brokers' forecasts and see if the two are compatible. Equally and opposite: "Profits for the year are not expected to match last year" is the kiss of death. Forget it, I probably wouldn't buy the shares.

Those are easy ones. But what do you make of this piece of classic directorese: "The company is repositioning itself to take advantage of changing markets"? Answers on a CD in no more than a million words please. Difficult, but I interpret this as meaning that EPS is unlikely to be ahead in the coming year and may even be static or falling. The director is trying to justify a lack of rise in the coming year. Again, compare this with brokers' forecasts to see if they are saying the same thing.

On brokers, as well as publishing forecasts, which as I say must be taken with a bucket of salt, they will issue a one word recommendation. These little snippets are famous. For example Buy, Accumulate, Add, Hold and so on are typical. The question is: should we pay any attention? In general, no, is my answer. However, a rare Sell snippet is interesting. If you have decided, having studied the company, directors' comments and so on as I advise, that it is a great buy, do not be put off by Sell comments from brokers. Look upon them as increasing the attraction of the share because these comments may well have, obligingly, driven the price down further. In fact this would be the absolutely classic contrarian value play. All the experts think the share is no good. You've done your research and are convinced they are wrong. When you come across this situation it will be your baptism of fire. If you can take on that one and win you will have made it. Ignore the noise. Believe.

Belief is critical. You have to believe in yourself almost without question. This can be very, very difficult when everyone is against you. You keep wondering to yourself: well, how come nobody else has noticed how undervalued this share is? The answer is simple really. 95% or whatever, the large majority, of investors are sheep, following each other and the latest trends. Amateur and pros alike. But a tiny fraction go their own way, the shepherds, guiding their contrarian value flock until the rest of the sheep join in, then mercilessly slaughtering them when you can no longer tell one sheep from another, when the value has been outed.

Maximising the upside is as critical to successful value investing as my other essential, minimising the downside. These two requirements of value investing are like the fists of a great boxer. Rely on only one of them and it's like you have one hand tied behind your back. You have some punch, but you will win only a limited proportion of the fights. But taken together they will deliver the knockout blow that will win most encounters. But even then, you'll still take the odd blow yourself. There are no certainties in the market, only varying degrees of likelihoods. I aim to grab most of those likelihoods with value.

Think about it: the logic is unassailable. You have a share with a very limited downside because it is already almost being given away. It has, if the forecasts work out, rising EPS, the key factor that drives up most share prices sooner or later. What can go wrong? After all, you've stripped out as much of the risk as possible from buying a shares. We'll see next week.

Comments and questions to the Value Shares board, please.