VALUE INVESTING
Attila The Hun

By Stephen Bland (TMFPyad)
March 17, 2000

There have been some comments on the value board lately as to how value shares might perform in a serious bear market: a crash, if you like. My personal experience suggests they will outperform. They will still fall, but by less than the market in general. This has been confirmed in the US by David Dreman, the well known writer on contrarian approaches.

You probably cannot avoid losing money on paper in the short term in a bear market, if you are in shares at all, whatever the strategy you are following. The only sure way is to pull out altogether whilst it is happening, in fact before it happens. But that requires timing skills. Both on pulling out early enough, and knowing when to get back in. This ability does not really exist in my view. You can be lucky, but repeated correct timing is near-impossible.

I must distinguish here between general value shares, usually taken to mean depressed blue chips on low P/Es and high yields – companies like Royal & Sun Alliance (LSE: RSA) yielding some 8% or so, where I just happen to have a chunk of the action right now – and pyad shares, those shares so deep in value, so attractive, that I can hardly believe my luck when I happen upon them. Often it seems with the latter that there must be something wrong. How can a share so attractive be so cheap? Is it true that that if something looks too good to be true, it probably is? And how come nobody else has noticed?

I do believe that both general and deep value shares would fall less in a crash than the market. The reason is that they have a floor under the price. This is the already low P/E, the already high yield. Their downside is minimised – not eliminated, never think that, but the chances of a severe fall are reduced, compared with other shares. This does not mean that they are guaranteed to fall less, just that they are likely to do so. But it could still happen. Share investing is about likelihoods, not certainties. You try to turn those in your favour with a certain strategy but you can never get rid of risk if you wish to be in equities at all.

What's a crash, anyway? Many sectors of the market have declined very substantially over the last year or so. 50% falls in some of the country's leading companies are common, Royal & Sun itself being a major example of this. What some commentators refer to as the "two tier market", with tech type shares on the one hand making the running and traditionals losing. Personally I don't actually buy this two tier idea. It's just a market with popular and unpopular sectors to me. There's nothing new here, except for people who have never seen this before.

There's an old saying about there being no old jokes, only old people. For every new born person, every joke is new. Markets are the same. Younger people, new investors, sometimes seem astonished by shares gaining twenty times in a year, like Baltimore (LSE: BLM), and by shares going bust like UNO. But it was always like this. Always will be. Unless and until human nature itself changes. But I don't think that is very likely at the moment. Never believe the "this time it's different" comments.

As I've often written, the market doesn't really interest me much, only individual shares. But even with deep value, making money will be much harder in a general crash across the whole market, simply because there is less interest in shares, any shares. Value, even if it drops less, will take longer to perform in consequence. The attraction is, though, that while you are sitting it out, you receive a fat yield that will frequently be higher than you would get in the bank. This does compensate for the wait and is one of the reasons I like it.

I'll probably never have a share that goes up twenty times in a year because even if my style led me into one early on, I would get out long before that happens, the value having evaporated. I am not interested in the next bit, the high risk bit. The reason is simple: for every share that goes up twenty times in the next year, there are a hundred that don't, that fall back, that would end up losing me money or making less profit if I stayed in. And above all I am an odds player. I am interested in a share only so long as I perceive the odds to be in my favour. The next guy can have the next bit. So because I invest everything on one or two shares, I cannot afford to take the risk that I might be on to a twenty-timer, because the chances are almost certain that I'm not.

Making long term serious profits in the market comes from repeat performance. Year in, year out, on average making high returns. This is the Buffett concept, although I don't follow his ideas much, except perhaps vaguely in the approach to buying cheap. It is only in the concept of compounding high growth over many years that I agree with him. But my style is completely different. I am not a long term investor. I do not even attempt to assess the long term growth of the shares I buy. I find the approach highly prone to failure, unless you possess Buffet's obvious nose for a business, which many investors think they do then go wrong because their olfactory sense is just not as developed as his. And it never will be: you are born like that, can't learn it in my opinion.

I'm more a kind of calculating speculator I guess, having little real interest in what the company does apart from its odour, only in whether there is substantial short term potential in its shares over the next year or two in most cases. And in this and several other regards I am not a Fool. I don't diversify portfolios, I don't in the main buy and hold.

But I am not advocating this strategy to others; most could not live with the risks. I write about it because people I hope are interested, without necessarily wishing to go down this road themselves, much as I might enjoy reading about someone such as Attila the Hun or something without wishing to emulate him. Mind you...

More correspondence on the value board concerned the sector approach to searching for value: "top down" as it's called, as distinct from the "bottom up" search for individual companies that I do. Top down has certain attractions. You can look in the FT for sector performance and find those that are down the most over a year, for example. Then analyse companies in the sector, utilising the usual value filters of your choice, looking for those that are unfairly depressed by the bad sector sentiment. Depending how tight your filters are, you will then come up with those shares that you think don't deserve to be down at all. Don't forget rising on year EPS, critical to this and to most value approaches.

Top down brings in the emotional gearing factor to which I referred last week: the relative weakness. Because if the sector recovers, you may get the double benefit of this, plus your share benefiting from having been unreasonably rated in the first place. It should therefore rise faster than the sector, if and when the sector recovers. This is the emotional gearing bit that can add to performance.

But I'm not a top down player, even though it has certain attractions. I'm just a whole market player, focusing on individual shares. I don't really want to know which sectors are in or out, even though I can't help noticing, the way we are swamped with excessive news these days. It cramps my style. It would direct me away from other possibilities. For instance there may be a pyad share lurking in technet. Unlikely at the moment, but let's say there was. If I go top down, I wouldn't even consider the sector right now. I'd miss my target. That's why it doesn't appeal. Having said that though, it often happens that my shares appear in bombed out sectors. But not because I am looking there, just that they are more likely to be there than in popular ones.

Once I've found my pyad share, then I'll smell it, see which way I think the wind is blowing. Part of the smell would be affected by my views and prejudices about the sector. For example if it was a specialist retailer, I would have to think very hard about going in because of the staggeringly high failure rate of such companies. Specialist retailers are probably the single biggest sector graveyard for inexperienced small investors who may believe that because they can see them, they must be good investments following early good growth. EPS forecasts, upon which unfortunately I have to place a certain reliance just to see a trend, up to a point, have a frequent habit of not being met in these companies, and profits warnings are common.

So whether you are top down or bottom up, don't expect many favours in a real crash. You will probably face immediate paper losses even with the deepest of deep value shares. And a long wait. This is where the real test occurs of whether you have got it right. A buoyant and rising market tends to make life easier for any investors. A static or sharply falling one is a great test of strategy. I think it was JM Keynes who said something like: "Never confuse competence with a rising market."

Comments on the value board please.

Related Links

• Value Shares discussion board
• Value Investing: Emotional Gearing