VALUE INVESTING
Emotional Gearing

By Stephen Bland (TMFPyad)
March 10, 2000

One of our readers posted a message in the past week about being a contrarian, and whether it was doing the opposite of what others say or of what they do. He concluded that it was the latter, and rightly so.

A share price will be depressed because it has been sold heavily, not because of what people think. It is their actions that create selling pressure. There is clearly a link, simply because people may act upon the statements of others. Press comment, for example, may push a share up or down, as similarly can the rumours on bulletin boards and so on. Market makers will mark shares up or down on Monday according to weekend press mentions, anticipating selling or buying pressure resulting from that. But ultimately it is people's actions, whatever the factors that cause those actions, that will move the price.

It is, though, highly dangerous in the stock market to be a contrarian just for the sake of it, without some fundamental reason other than merely trying to be different. And I speak as one who has made a whole career out of being different; and not just financially. It will work sometimes simply because crowds are frequently wrong, but not often enough to make money and there will be many periods when it fails. This approach could be described as a reverse relative strength (RS) system: relative weakness (RW), if you like.

The RS investment approach, followed by various mechanical schemes on the Fool and used by many other investors in non-mechanical styles too, is based on following the crowd. It assumes that the favourite shares they have been chasing will continue to be chased ever higher, for a certain time anyway, enough for the investor to capitalise upon. The style has met with great success over quite a few years now.

RW then, would select shares that the crowd have ignored. Unloved, unwanted, cast out like the child characters that populate many of Dickens' novels. As a pure strategy on its own, I suspect it would invite disaster. But I am concerned here with its use in value investing – the pyad version.

As it happens I like RW, but only as an additional factor on top of all my fundamentals. But I don't insist upon it. I would have no hesitation in buying a share that had beaten the market over the last year if my other requirements were present. The reason I like RW as a little bit of icing on the cake, though, is that it gives me additional indication that the share has been ignored or sold down by the market. Not only is it cheap on fundamentals but investors have been especially disinterested in it. And disinterest interests me. I like to bet against the crowd.

I call this emotional gearing.

Normal financial gearing refers usually to the debt/equity ratio. Companies are funded in two primary ways; equity and debt. Each has a different type of return which distinguishes it from the other. The characteristic feature of equity is that there is no limit to the return available to the investor. In contrast, the characteristic feature of debt is that the return is fixed, limited, usually by an interest rate. A company with shareholders equity, equal to net assets, of 100m, and with debt of 30m, would have gearing of 30%. For most investors a certain level of debt is quite acceptable. But because I am obsessed with minimising the downside, lowering the risk, as regular readers will know, I look for no debt at all. This is the D in "pyad". I want net cash, meaning either that there is no debt and pure cash, or possibly that there is some debt yet the amount of cash exceeds it to give a net cash position.

The purpose of financial gearing can often be to increase the return on the equity. By funding part of your business with debt at a fixed return, provided you earn more than that fixed return on whatever it is that you do, you increase the proportion of profit available to the unlimited return equity investors. And the reverse is true if you do badly. A well-known story.

But that is financial gearing. Boring accountancy stuff. Who wants to be an accountant? Who wants to make staggering amounts of money as people get trampled to death in the stampede to your office, waving cheques of astronomical proportions at you, just because you know how to save a few bob in tax? Not me.

Emotional gearing, then, is the concept that there is a wave of negative sentiment that has been directed towards the share over recent times, that has added to its undervalue as perceived by the investor. The idea being that not only will the share go up to realise that perceived arithmetical undervalue, but that people might start to give it extra sentimental attention in addition. That latter part is the emotional gearing bit that might add to the subsequent price rise if you have got it right. That might give the share little bit of edge over one that did not start out with strong RW. Not essential, as I say, but useful if it's there.

Remember that the underlying concept of value investing is to anticipate a re-rating by the market. You against them. You think they have got it wrong, you believe you are right and that they will see the light in time, see it your way. Once they see it, you start to lose interest and eventually you will take your messianic fervour elsewhere, typically whilst the share is still rising, always leaving something for the next guy.

So if a share has got serious RW, and this is quite common with pyad shares anyway, it means that there is possibly some additional mileage in the price rise, compared with the case where there is little RW or even perhaps RS. The additional mileage stems from the price moving out of the RW area, perhaps to level with the market or start to beat it.

As I say, it is not a critically important point and would certainly not prevent me buying an otherwise qualifying share, but it definitely adds to its charms. The final dab of intoxicating perfume on an already attractive lady, or man, with whom you have already hopelessly fallen in lust in any event. You are going to try and score anyway but if there is any small thing that might improve your chances, well you're not going to throw it away.

In the highly unlikely event that I was presented with a dead tie between two pyad plays – two shares that appeared identical in prospect to me in all the usual fundamentals, except that one had RW and the other had lesser RW or RS, I would do one of two things: either buy both or buy the RW share. Buying two shares would result in me holding a portfolio. Well, this has happened in the past, but it is something I don't like to talk about too much. A bit like having had a non-serious though socially unacceptable disease at some point in your life about which you'd rather keep quiet. As a result I expect that I would buy the RW share with all my dough.

In practice though I don't recall ever having been presented with such a situation. There will nearly always be other features that distinguish pyad shares on the rare occasions when more than one is thrown up, which will typically be in severe bear markets. And we haven't been there for quite a few years.

Comments on the value discussion board, please.