VALUE INVESTING
The Roots Of Value

By Stephen Bland (TMFPyad)
December 17, 1999

In what is probably the last serious article by me of the year (and no, I am not going to say of the decade, century and millennium as every second writer unable to escape the confines of corny comments is going to remark) before I go into the seasonal attempts at humour, I am going to return to the roots of what I understand by value shares.

Incidentally I promise, as I did in my tax series, that any attempts next week at funnies will most definitely not contain something about Santa Claus reviewing his portfolio and deciding that sleighs.com plc is definitely going to be the next big thing. I loathe such Christmas writing unless the author possesses almost superhuman talents of humour, which I certainly don't and hardly anyone does, and hope we don't see any of it round the Fool. People seem compelled to do this at this time of year. I am guessing, but if you pick up a copy of "The Anorak", the trainspotters' magazine Christmas special edition, I would not be surprised to see an item on how Santa Claus goes sleigh spotting and has just seen a 20-44-16 with double bogeys.

Unfunny funny writing is a crime. That probably makes me Mr Big in that case.

In my first article, back in August 1999, I defined a value share as follows:

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

Since then there have been arguments on the value board on what constitutes a value share. The problem arises because the word "value" has no clear definition as far as shares go. It is used by people following the "cheap on net present value of future earnings style" as well as those following the "cheap on fundamentals style" like me. It has also been used completely indiscriminately by some readers to describe any old share which they think is cheap, sometimes for no reason at all other than that they just like it. Thus on my own definition above, both styles merit the term "value."

Whatever takes your fancy. Personally I have no interest in the net present value approach, supposedly used by Warren Buffett, but which I doubt that he does in reality. I don't know, of course, but I suspect that someone like him just goes on gut feel, instinctively knowing when a share appears cheap and then having the patience to hang in there for years. I've written about this many times before, on the futility of trying to package his approach. I am just guessing here, by the way, I have no evidence for my assertion other than the circumstantial one that we don't seem to be overrun by megarich investors following the what they believe to be his scheme. I know I've said this repeatedly but I think it bears repeating. Nobody has successfully challenged it, that's why.

But whatever I think of its merits, I would agree that net present value is indeed "value" of a sort. But a completely different sort to low P/BV, P/E and the rest of the fundamental type of criteria I use and comment upon here.

Some of these arguments on the value board became rather heated with one reader accusing me of being a bit of a cult. I think he made a spelling error.

It is true that I did want the board to stick to the value criteria as I understand them, not just the pure pyad approach, but that kind of thing where a share appears cheap on the usual fundamentals. For example value works quite well often without all four pyad filters. P/BV<1 is the one that is usually dropped because it is the hardest to find. I like it because it helps to reduce risk but for those not worried about that, success is still pretty likely assuming all the other usual things are in place like rising eps forecasts and so on. Similarly many people are not too bothered about net cash and will accept a certain amount of debt. Again it will work quite well but with a little increase in the risk. Others may use further tests like Price/Sales or Price/Cashflow. Price/Sales is in fact quite a popular ratio amongst value investors, though not one that I personally use.

A good book on various filters like this is O'Shaugnessy's What Works on Wall Street. Here the author tests these over long periods like forty years for their efficacy. However he used portfolios of fifty shares, beyond the reach of most small investors. It may not work so well on small holdings of a handful of shares where the risk is far less spread but nevertheless the book is instructive. This is a purely mechanical approach though, and not one I personally would use in value investing. For one thing, I have few holdings and the conclusions are not valid for just one or two shares. And for another, I want some input of my own other than just the arithmetic criteria: the "smell" about which I have written.

I accept, though, that not everyone is as anal as me about having as little risk as possible; minimising the downside, to use my mantra. Certainly, giving up on some filters will dramatically increase the number of shares fitting the approach. I am more than happy for people to discuss such things on the board. Just because I advocate castration for those not following my plans to the letter does not mean that I am not totally open-minded about the whole thing.

I've made some comments on a thread that developed on the investment strategies board following Rob's (TMF Essex) interesting article on alternative indices and tracker funds. They were discussing an index based on something other than sheer capitalisation like the FTSE 100. Suggestions were company profits and similar ideas. In my view the ultimate objective test of any share approach, as I said there, is the performance over a period, in other words the price movements. This is what the investor wants to know at the end of the day, how much has he made or lost. All the stuff in between regarding analysis, index tracking, or whatever pleases you is just a means to that end. Making money.

The relevance of this to value is that in the end the objective is the same; making money. Of all the endless discussions about strategies on our boards and the large number of other media, it seems to me that people often lose sight of the target. The laudable aim of making as large an amount of folding stuff as you possibly can in the market, preferably with the least risk. That is all that matters after all the talking has been done.

But how many people with all their ideas we read about actually achieve this? Few, I venture, in anything other than modest amounts.

I hope that with the aid of the Fool there will be an increasing number of people able to make real money in the markets. Not just by tracker-style 12% returns, but to grow wealthy. Through value or whatever appeals, although I believe absolutely that value is the way to do it. Can you turn £10,000 into £1m in ten years? All it takes is 58.5% annual compounding. A tall order. You need discipline, patience and the right methods.

Questions and comments to the Value Investing board, please.