VALUE INVESTING
If The Cap Fits

By Stephen Bland (TMFPyad)
April 7, 2000

A lot of discussion on the value board over the last week on the merits of small cap companies from a value investor's point of view. As regular readers will know, with my pyad (Price, Yield, Assets, Debt) approach I have a minimum market cap of 100m. This is not absolutely rigid and I might go a bit lower for a good one, but I am very unlikely to go below about 80m.

A small number of readers appear to take this as a personal insult, but it's only my way. And despite what some people seem to think, the value board is not there to represent my views alone: none of our dedicated strategy boards are there for only one person's ideas. This concept, that the board exists only to propagate my particular ideas, is one of which people accuse me, or it (the board) if you like, from time to time. I certainly never set out when the board was set up to create this impression and it is not one that I desire at all. But if someone asks my opinion, I am going to deliver just that, my opinion, not somebody else's. In doing so, I am conscious that my opinion will sometimes clash with that of other readers. But that's what makes a discussion.

Value investing, all investing really, is an art, not a science and there are few if any absolute truths in it. There are loads of different approaches which can be described as value, even whilst limiting this to the fundamental kind to which I am referring. There are a large number of different ratios and filters that can be applied when selecting shares and I have my ones, which everybody knows about, and other readers have theirs. Some may choose to use my ideas, others may not or may use a partial version with their own modifications.

It is in the nature of a discussion board, the very definition of it, that we talk about different shares and different approaches to value. By my nature, I am highly opinionated and I know this irks some people. If a reader likes small caps, and I say that I don't like them and give my reasons, that is just a difference of opinion. The problem arises though because of the influence of the board. I can't measure the effect, but it has a lot of readers. So, for example, if someone has a value small cap that they are advocating, and I write that I am not comfortable with small caps and avoid them, it might happen that the reader who wished to draw attention to the share becomes annoyed. I don't see why though, really. By posting such a message, the reader is inviting comment, positive or negative.

The value board attracts many highly skilled and knowledgeable investors as well as beginners keen to learn the strategy. It is, thankfully, largely free of the sort of half-baked recommendations or criticism that one can often read on other boards. This, I believe, is because value requires much more of an intellectual approach than some other investment methods. It requires concentration on numbers, an appreciation of the elegance of certain key ratios. By its nature it excludes hype and hot air. It steers you away from anything that is not real. But in return it demands that you do your research. Hence the attraction to a certain type of individual that finds this kind of thing interesting. Share anoraks if you like.

And perhaps most interesting of all, the product being sold by the companies concerned in a lot of cases is almost irrelevant. That is quite astounding in a way if you think about it, and is contrary to the way a lot of investors operate. Although I have a soft spot for certain types of share, like financials, and certain prejudices bordering on the fanatical against others, like specialist retailers, the small investors' graveyard, I will in fact buy almost any share that meets my criteria and whose smell I find inviting. A quick think back over some of my shares over the last few years includes financials, packaging, housebuilding, shipbuilding, photocopier renting, mining, steel, and so on.

When I look through the Investors Chronicle each week, or some other source like REFS, I check for the presence of my four basic filters first. I do that before I even notice the name of the company or what it does for a living. Those latter matters are secondary. If it doesn't pass the pyad test then I am not interested. Only then, if it does, will I even start to look further at it.

Going back to my opening theme, small cap prejudice, perhaps I should comment here again on why I have this. I've written about it before but maybe it needs reiterating. I'll start by repeating one of annoying clichs: Minimise the downside. Small caps have for me proven to have more downside than larger caps and hence increased risk.

I speak from experience. I did not have a minimum market cap some years ago. I used to go into some real micro caps – 10m, that sort of thing. However the failure rate was much higher. In refining my approach over many years, I have gradually tested and rejected certain concepts. Not in a scientific way, but just through my personal experience, which is probably in consequence biased, but works for me.

I examined the reasons why a number of small cap shares, which were pure pyad plays, went wrong. In a similar way to the process by which the whole concept evolved in the first place – examining the reasons why people lost money, not why they made it, which is so often luck, particularly with small investors, unable to repeat their success over years.

The primary reason that too many small caps lost for me was that they sometimes failed to meet the expected EPS growth rates. The kiss of death. EPS growth is the driving force behind value realisation. Can happen to any share, but failed forecasts and profit warnings were much more prevalent with small caps than larger ones. There were two underlying causes of this. One was that the directors had less integrity and were consequently more willing to be falsely optimistic about the future, probably to ramp their own shares which they probably knew were going nowhere. So I came to lack faith in their utterances, normally something to which I like to attach some credence. Comments in annual and interim reports etc are an important source of information about the likely direction of EPS and other matters. The other cause was that few brokers published forecasts, often only one, and that would be the tame company broker. Without a range of views the risk of error is increased.

The secondary reason why small caps failed for me more often, was that even if everything went according to plan, in some cases nobody cared anyway. Most institutional investors, who form the bulk of the market, have little interest in small caps because they have sums of money available which are simply too large to invest in such companies. There is no point in having on paper the perfect value share if nobody else is going to buy it. The value will not be outed in a reasonable time scale, whatever I thought about it.

These two reasons together convinced me over time that I must have a cut-off point to eliminate such shares and decided upon 100m. Arbitrary of course, a round number, but having decided to make such a limit for myself, I had to make it somewhere. That figure is still pretty small by stock market standards. But it was a trade-off. If it was too high, I would make it too rare an event to find a pyad share at all. Too low and I was back to the above mentioned small cap problem. 100m produced a good balance.

I never looked back. This refinement, whilst reducing substantially the number of pyad shares that can be located, raised the quality of those that were found immensely. The number of failures since, that is those where I have actually lost money, is almost none. Previously I had more than I would have liked. Mind you the one serious loser I have had over the last few years, British Steel, was nasty. From memory I dropped something like 20% or so before I decided the value had gone out of it as the fundamentals had changed and I cut the loss, a figure involving several zeroes I regret to admit, even though I got a couple of fat divi cheques whilst waiting.

As a matter of interest that was one where I bet against the entire panoply of financial journalists' opinion. Not one good word could I find anywhere at the time I went in for British Steel. This was so powerful that I thought I had struck gold. A FTSE 100 share too, at the time. Normally when a consensus is so strong, you are bound to be right by going against it. Time and again I have done this and won. They just had to be wrong. I even remember thinking, madly, that if this one comes off, I'll give up and stop risking an amount equal to the GDP of a minor subcontinent on one share in future. They were right! And I never gave up.

Comments on the value board, please.

Related Links

• Value Shares discussion board