VALUE INVESTING
What Can Go Wrong?

By Stephen Bland (TMFPyad)
September 3, 1999

Last week I wrote that there are no certainties in the market, only varying degrees of likelihood. With my style I attempt to tip the balance of likelihood my way by trying to cut out some of the riskier aspects of owning value shares. But even when all that has been done, by using the methods I have outlined in earlier articles, you are still left with a degree of risk. That will be always be there despite all the belts, braces and every other kind of support, simply because investing in shares involves some chance; you cannot remove it entirely if you wish to be in shares at all.

The outcome of the degree of chance remaining with my way, is that an investment occasionally falls and you lose money even though you have taken all the downside minimising steps. It happens, and the possibility must be faced. Not often, or else I wouldn't be here writing this stuff, but it does occur and nobody following the value style should be unaware of losses occurring from time to time. You can't win 'em all!

The interesting question, naturally, is why the occasional loss? And can anything be done about it? The answer to the second point is pretty easy. No. It's the result of the limited level of risk remaining with the approach. But some damage limitation procedures can be adopted which I'll show later on in this article. But this is why:

Value shares are attractive because of a particular set of fundamentals that appeal to the investor: the kind of ratios and facts I have written about previously. These are actual figures in the main, based on the latest published results of the company plus, often, some outside comments from brokers or the press. It is usually only the forecast earnings per share that is not actual but based on some sort of estimate. But other features like Price/Book Value will be based on actual figures.

So the first obvious thing that can go wrong is that forecast earnings per share are revised downwards, perhaps substantially. I have mentioned before that rising EPS is critical to increasing the share price of a value play. A margin of error must always be allowed in any case, because of the unreliability of forecasts. But if the forecasts go seriously wrong, you have lost some or all of your rising EPS, and the share will no longer be a good value play, by my rules anyway. The price may not rise at all and can easily fall well back below the purchase price. This is probably the most common reason for a failed value share.

The second most common problem, often causing the price to fall sharply, is that the company develops some unforeseen difficulty. Perhaps some illegal, fraudulent activity is discovered causing doubt to be placed on the company's viability. Or maybe a subsidiary suddenly gets into financial difficulties of a genuine nature, rather than fraudulent. The company could be dependent on a particular commodity whose price has risen markedly. Whatever, such events (which you cannot possibly have known about when buying) will probably damage the share price.

Once the share price has fallen for some reason, as I've stated, and you are sitting on a loss, there is a nice dilemma. Should you hang on for a recovery or take the hit and get out? The answer lies in the nature of the reasons for the fall.

Before I go on, I should say that just because the price has fallen does not mean you should sell. This happens often. If there are no discernible reasons for the movement it is probably just noise. And one of my sayings is: Ignore the Noise. As a fervent believer in your own value stock picking skills you therefore stay in, knowing you are right. But in this article I am referring to price falls where there is a clear reason, where something has gone wrong, such as the possibilities mentioned above.

So, if the reasons for the price fall are known, such as a profits warning, then immediately re-assess the share. If it no longer exhibits all, and I mean all, the value characteristics that you sought originally then cut it dead. Take the loss. As a value player, never stay in a share that has gone wrong. Remember that we are not long term investors. The value player can't afford to hang around for a recovery that might never come and never, never falls in love. We are heartless, ruthless, cold, number crunchers. We are far more unemotional than the "unemotional" investors seen elsewhere on the Fool. Only the robotic, mechanical investors possess more "unemotion" than the value player.

Better to have money in the bank than continue with a lost cause. It is not easy to do this. I have been there and I speak with long experience. You sometimes try to talk yourself into believing that the bad news is not that bad and it will turn the corner. Don't weaken, get out immediately. Don't even allow yourself time to think any more about it. The moment you have appraised the bad news and realise that the share has lost its value according to your particular rules, get on the phone to your broker.

People, not just value players, often say that they have difficulty in knowing when to sell shares. I don't suffer from that particular malaise. If I am winning I sell when the deep value has mostly evaporated. If I am losing due to some bad news, I sell if the share no longer has the value features that were present when I bought. Thus in both cases, value tells you more or less when to sell. It is simple. You bought the share according to a picture of value that you painted, whatever your approach. You sell when a lot of that picture has been destroyed, usually by making money but occasionally by losing it.

In my first four articles on value investing I have laid out the general approach, illustrating both my particular super value style and the more general, somewhat less restrictive ideas that other value players use. The general idea, though, is to locate shares through fundamental analysis that are unreasonably priced at well below what the investor believes they should be, and to profit from this in the short term.

Having laid out my wares on value investing, here as a recap is a list for quick reference of my little sayings culled from these articles and others, which no doubt will irritate many people. Future articles will look at specific case histories of value shares, perhaps some of the psychology of contrarian investing in general, crisis investing and other points.

Minimise The Downside

Treat your relationship with the market as a war. Each value share is a battle in that war. The market is your enemy and will destroy you if you allow it. Attack only from strength, never weakness. Your strength is the cheap fundamentals. Your weapons of strength are factors such as Price/Book <1; low Price/EPS perhaps under 10; high yield; no net debt, preferably loads of cash. Other value weapons include Price/Sales and Price/Cashflow. Never use only one or two, it's like fighting tanks with popguns. I personally go for the first four in this list, what I call acronymically the pyad approach.

Maximise the Upside

A share that appears undervalued on fundamentals may remain that way. Something must happen to drive out the value. I believe that something is rising EPS. Take forecasts with plenty of doubt, allow a margin of error. Look for something like a 20% gain in forecast EPS over the last actual. Don't buy on takeover hopes alone, it might never happen. Takeover possibilities come with the territory anyway, thrown in for nothing because if it looks cheap to you, it may well look equally cheap to a bidder.

Ignore the Noise/Believe

Once you have made your decision stick with it until something happens. Ignore price falls that are not based on news, that are just market noise. There is a lot of that around. Develop fundamentalist religious fervour about your decisions. You must believe in yourself absolutely and ignore outside comment once you are in, unless of course there is real bad news, which is not noise, in which case get out if it no longer makes sense.

Always Leave Something For The Next Guy

This is where you are making a nice profit. Don't hang on, don't fall in love. The shares won't love you back. Sell when the share fundamentals approach average, don't wait for it to overshoot, don't try to extract the last penny out of it. If you try to call the top, you'll more likely watch it start to fall and lose a lot of the gain. Let someone else carry the higher risk once the main value has been outed by the rising price. And never regret it if the share goes on rising after you have exited. Don't even look at it any more. Spend your time on the search for the next play.

Post your comments and questions to the Value Shares board.