VALUE INVESTING
Sector Woes

By Stephen Bland (TMFPyad)
January 14, 2000

I have been given a hard time recently on the value board over my comments claiming that sectors and markets should be of little interest to value investors in general; at least, to those following the bottom up approach like me, rather than the top down style.

Just to explain the meaning of the latter points above: a top down investor would look for depressed markets or specific, unfashionable sectors within those markets first, when trying to find undervalued shares.

For example in the UK market, in 1999, general retailers and also water companies were amongst the poorest performers in the year, both down heavily. Against this, tech and Internet shares were massive winners. Thus someone looking for undervalued shares might use the approach of homing in on the retailing and water sectors, trying to find good value shares that have been depressed, unreasonably so, by the poor sentiment prevailing there. When a sector gets beaten down, the good will usually fall with the bad.

So, for example, if a company in a depressed sector – depressed probably for good reason, say because of falling EPS among many of its constituents – still appears to be showing a good rise in EPS and has other value features like low P/BV, or whatever is sought, then that share may be a good value investment.

A bottom up value investor typically pays no interest to the market or to sectors, but will simply trawl for shares possessing the particular criteria that they are seeking, across the whole market. Those criteria that are relative to the market, such as P/E and yield for example, will then be derived from a discount to market averages. My personal limits for a long time have been a maximum P/E of 2/3 of the market and a minimum yield of 50% over. I might give way to some extent on the yield for a good case, but very rarely on P/E except maybe in a real bear market where the average P/E would drop to say 10.

I am not claiming that either method is preferable. This is simply a matter of personal choice. You use whatever you find most interesting and that makes money for you. Although I personally do not follow top down, I have known people to profit from it.

Quite often, the value shares revealed by a bottom up search will actually happen to be in depressed sectors. This is no accident, of course, because value shares are frequently, but not always, those that have fallen a lot. If therefore there is a weak sector, there is a fair chance that it may contain the sort of value shares I am seeking, simply because their price has come down. But not because I am looking for a particular industry.

My main antagonist on the value board concerning the sector thread thought that because I had traded a couple of housebuilders last year, this meant that I had been moving in on that sector. He therefore could not see why I was advocating that people ignore sectors if they want to play value along similar lines to myself, when I had appeared to be doing the opposite. But that was not the case at all. It was simply because the housebuilding sector was depressed that a search across the whole market threw up one such share, then another some months later.

My particular concept of value is universal and unrelated to sector. It is for example conceivable that certain tech shares could exhibit deep value in a crash of that sector. Not many, though, because there would have to be EPS and dividends, which immediately eliminates a large number of them before you start. But the concept is still there. All it is, at its basis, is simply the age old commercial process of buying something cheaper than others in expectation of a sharp price rise to level out the differential. The share doesn't really have to do much if chosen well, the market does it for you as other investors realise eventually that the share is underpriced. It is unlikely to permit a share that is too cheap to go on being treated that way.

As a generality, the kinds of shares I have traded over the years have tended to be in basic or boring industries, which I have written about before. As I've said, boring is beautiful to the value player. Things like shipbuilding, housebuilding, supermarkets, copier renting. One departure from that kind of thing was the mining company Billiton (LSE: BLT), which in its early post-flotation days was a pure pyad play. Another is London Pacific Group (LSE: LPG), an insurance and fund management company with a venture capital arm. But those are exceptions.

In every case, I never looked at any particular sector. The shares found me by laying out their attractions on display in the form of their fundamentals. If the stock market is like a large department store then my shares are not in any particular department, they are in the bargain basement where all the stuff nobody wants is dumped waiting for the likes of me to pick over, looking for real bargains amongst the rubbish.

Having found my shares and evaluated them arithmetically I turn to gut feel, or smell as I call it, as people who read my stuff will know. It is in that area that a general feeling about the industry may possibly be of relevance. Not always, but on some occasions. Returning to the general theme of housebuilders, and to one of my successful plays a while back – Fairview (LSE: FRV) – in particular, it so happens that this company builds lower price properties around the London area. I happen to know a bit about the property market, and it was demonstrably clear to me at the time that this was a boom period. New properties in London were selling very fast and there was no reason to suspect that Fairview would be immune from this trend.

Consequently what this observation gave me was a little emotional comfort to support the rising EPS forecast. It improved the smell of Fairview. My limited, but in this case relevant, knowledge of the London property scene, helped to improve the quality of the share to me. It is quite likely that I would have gone in anyway because of the attractive numbers, but nevertheless any odour-improving factors are clearly welcome. As indeed are odour-polluting factors that put me on my guard, that might just turn me off an otherwise numerically attractive situation because I simply don't like the smell due to some additional, non-quantifiable risk element.

So that's as far as I'll go towards acknowledging that a sector may just, in a few cases, have an influence on my judgement good or bad. But mostly not, because I know little or nothing about most industries anyway. To take one example, last year a winner was API (LSE: API), a specialist foils packaging manufacturer. Now what I know about that industry can be written in block capitals on the head of a pin. I went in purely on the attractive fundamentals and certainly did not do any analysis of the share relative to the others in that industry. It was simply too cheap by all the benchmarks I use and that was it. And there was no bad smell that I could discern to put me off.

It is even possible that a lack of detailed comparative sector and other analysis is useful. I have commented before on the tendency of some investors to over-analyse things when making their decisions. Too much information is considered and the person can end up, paradoxically, making a poor choice through excessive consideration of all possible angles, being swayed by marginal considerations over crucial and fundamental ones. There's only so much that is really relevant, that a human is capable of processing and consequently arriving at a good decision. Information overload is counterproductive. Travel light with your investment tools.

With me, it's just a few basic points. If they work, then stand back for a moment, inhale deeply and see if you get any malodours. If not, then that's it and in I go.

Broker's reports and similar analyses of shares often tend to be biblical in their length and complexity. If I was writing reports for value shares the whole thing would usually be just a couple of paragraphs.

Comments on the value board please.

Related Links

• Value Investing – Something Smells
• Anatomy of a Value Play
• Anatomy Class Two – API
• Anatomy Class Three – The Fairview Story