VALUE INVESTING
Something Smells

By Stephen Bland (TMFPyad)
December 3, 1999

This week I propose to go on about smell. Gut feel. Call it by whatever part of the body appeals to you.

I have a problem with smell. Not my own you understand, not the true meaning of the word, but the metaphorical sense in which I use it to communicate the non-quantifiable essence of a value share.

People go to great lengths, write many books, to discover the secret of highly successful investors like Warren Buffett. They try to turn this into a repeatable formula so that anyone can, by following the principles involved, become as wealthy as the individual concerned.

I don't believe it can be done by most people, at least not simply by quantifying and analysing the approach then sticking it in a book and selling it. The evidence for my assertion, one that I have often repeated before, is: how come there aren't millions of Warren Buffett investalikes running around?

Maybe there are, like those who believe in aliens, and we just can't see them. Think about it, all you have to do is fork out a few quid for a book, amass the necessary start dough, and there you go. Easy, eh? But somehow I doubt that more than a tiny number of people manage to grow money in shares Buffett-style or using that of other gurus.

By the way I obtained the idea of my assertion from no less a person than Stephen Hawking in answer to a question on time travel. He commented that the best evidence against the existence of time travel was that we never seem to come across hordes of tourists from the future.

As I said, I believe that it is not possible in most cases to acquire the skills of a great investor from a book. The interesting question of course is: why not? And this brings me back to smell.

It is because people do not have the investment nose that accompanies the skills of such people. The concept that it is not just about the figures, not just about calculating present values of future EPS or whatever and comparing that to the current price to see if the share is cheap. We can all do that. It goes wrong in a massive number of cases. Why? Because there is a secret ingredient, the smell, the gut feel, that, if you possess it, leads you to be right more often than you are wrong. Those who try and emulate the masters in a great number of cases will not possess the master's nose; the unquantifiable something that great investors possess.

I believe therefore that it is not all in the figures. It has to be that way because almost anyone with half a brain can do the kind of analysis that accompanies the arithmetical bit of searching for good shares. Any number of books, including our own Fool ones of course, will teach you the basics of share evaluation.

But the crucial point is that mere numerical analysis is not always good enough. Anyone who has been following shares and trying to make money for years will know this. It is in fact very rare for investors to make stacks of real money from shares. I'm not talking tracker or similar returns here, I am referring to becoming wealthy from modest beginnings in a reasonable time frame.

Can you turn, say, £10,000 into £1m in ten years? The number of people who will achieve this is almost non-existent. To achieve that return, multiplying your start capital by 100 in that time, requires average annual compounding of 58.5%. A magic figure. And you will never achieve it by copying the style of a guru, in my view, unless you possess the guru's nose. But such noses are not handed out by the big guy to everyone willy-nilly. Just like being a great tennis player, or great anything, is not handed out frequently. It wouldn't be great if it was, of course.

I want to look at this closer because I think it is interesting. Most people have some kind of talent, skill or whatever, something at which they are good. It may be music, maths, sport, investing, any kind of game or hobby and so on. It may be business skill. They may not be world class, but they may well be better than many others at whatever it is. I think this is a fairly uncontroversial point.

If you are a decent musician, you will have a feel for the instrument. A natural ability to express it whilst others are sweating over piano lessons. If you can play a reasonable game of tennis or squash you will be aware of the sense of knowing how to play the ball. Coaching is still critical of course, but given two people with equal coaching the one with the greater natural talent will clearly be more successful.

It is a fact of human existence that we are all different. We cannot at present escape from that prison. Know yourself first before you attempt to make money in the market.

For example, I can't draw. I just don't have the talent, even at a simple level. I always admire those who can sit down and sketch a likeness of a person, scene, whatever. It just comes naturally to them, whether or not they have had training.

Having tried to smell smell, the obvious question arises as to whether it can be learned. Or is just something with which you are born? Unfortunately for a large number of investors seeking the holy grail of rapid wealth accumulation in the market, I believe you cannot learn it. And that is why there aren't huge numbers of Buffetts around. You just can't distil, bottle and inhale the secret ingredient that someone like that must possess.

People continue to try of course, and if you make decent returns then great. We offer a lot of help here at the Fool to achieve that. But what is very hard for me or others to get across is the secret weapon bit. The thing that powers decent returns to serious money. That last step is the threshold that few will ever cross.

So when I write about smell to people, I have difficulty in explaining it. In trying to make people develop it. I'm not even sure if it is possible to develop it as I said above. Not that I'm in the Buffett class, of course. In any event it is not infallible, just right more often than wrong. All the big investors go wrong sometimes, small ones too of course. But the better ones go wrong less often. They are also willing to risk substantial sums, accumulated from previous success. This reinvestment is critical to making it big.

Why is that I find certain shares attractive and others not, even though the value fundamentals may be similar? I am not sure I really know. Maybe it is experience of certain types of companies or industries being less likely to do well than others.

For example many will know that I have an aversion to specialist retailers. This is not blind prejudice, it is because the failure rate is very high. Such shares rarely become deep value anyway but apart from value, I don't like them and see too many small investors, non-value players, often beginners, losing money in them.

But I'm not against all retail shares. I was in Somerfield a few years ago, not long after it floated in its present form. It was a textbook pyad share at the time and went on to perform brilliantly. It did well for me. The recent collapse came much later, long after I dumped it. My retail aversion does not extend to supermarkets anyway.

Here is the process. I find myself a pyad share in my trawls. The figures all match up. At that point I am like the reader of the book, following the numerical bit. Great. Hang on though, stand back, don't want to get too involved. No overanalysing, that's bad for business. Think. What do I feel? I'm a control freak. What does this share tell me? In or out? The decision will be almost instant. Some shares just scream at me: Don't touch! Others are begging to be bought. But I still have trouble trying to explain it to people.

Maybe I'll try again some other time.

Meanwhile, post your comments and questions to the Value message board.