VALUE INVESTING
You Can Bet On It

By Stephen Bland (TMFPyad)
September 8, 2000

A look at strategy this week, instead of the usual company review.

I have always been fascinated by gambling. Gambling and investing are closely related, and in a mathematical sense are merely different points on the risk spectrum.

My dictionary defines a gamble as "an enterprise undertaken or attempted with a risk of loss and a chance of profit or success."

It defines an investment as "a thing that is worth buying because it may be profitable or useful in the future."

Typically a gamble would be a situation where you are far more likely to lose your money than in an investment. However it is clear, to me anyway, that many share investments are really just gambles, and many investors are really just gamblers. But I am not referring to penny stock or tip players alone.

I have mentioned often that I am an odds investor. By that I mean that I will go into a situation only where I believe that the odds are as much in my favour as I can manage, as is possible in shares. The potential rewards, difficult to judge but you need to if you want to weigh up a situation, have to be greater than the risk.

My point is that gambling takes place where the potential rewards are less than the risk and I believe that the main reason that small investors go wrong is failure to appreciate this simple truth. They will buy shares where the chances of failure are too high compared with the chances of success.

It is easy to quantify this in a game where the outcomes can be known, just to illustrate the point. Rolling a dice for example. Six possible outcomes, chance of forecasting a number 1/6 (or odds of 5-1 in bookmaker parlance). A bookie would therefore have to offer you less than 5-1 to make money in the long run.

Gamblers, or uninformed investors, may play this game where the bookie is offering 4-1. They might win sometimes. If they play it regularly they will lose; they must lose. No professional gambler who understands odds – and all professional gamblers understand the nature of what they do – would ever play this game at those odds as part of their profession. Only mug punters would do so on a regular basis, or those who understand that it is a losing gamble but do it for fun.

And before anyone accuses me of playing the lottery at around 14m-1, which I do, I point out that I gamble only £1 per game and the potential reward is so great in return for a very small stake that I consider it well worth it. But I would not stake large amounts, and it is gambling pure and simple, for fun. I am not against gambling in very small ways like that.

Back to shares then. What I am looking for is a play where the potential reward is out of line with the risks. Where the downside is low and the upside is high. Obviously you cannot quantify the risks with shares, like rolling a dice, but to continue the analogy, I am looking for the dice roll where the bookie is offering me 6-1. If I repeatedly play a 5-1 risk with a 6-1 reward, I must win in the long run.

In proper gambling such events do not exist. Dice throwing and casino games are perfectly predictable situations, analogous to the theoretical perfectly rational stock market. But in the real world the market is not so rational as a game of roulette. Like roulette it involves risk, unlike roulette the odds cannot be predetermined. And also unlike roulette, skills can be brought to bear which swing the odds in the favour of the investor. Whatever you do in a casino, the odds on a strategy are known in advance and they will favour the house. Not so in the market.

As I say, it cannot easily be quantified, but there is a risk spectrum amongst shares. Some are more risky than others. I have no figures, but say a share picked at random has x chance of producing a certain performance over a certain time. All the rest of the shares in the market will have chances of producing a similar performance that are either about the same as x, or rising to much better and falling to much worse. You could rank them, and it could be done with real examples, only historically of course. Doesn't mean it will repeat the same pattern, but the concept is true.

Don't worry, I'm getting to the point!

Now let us assume small investors are rational. Wrong, but let us assume it. If this were true, everyone would buy shares with the lowest risk. The only reason they do not is that they perceive that higher risk shares offer a higher reward.

But, and this is the point, very few seem to realise that the potential reward for higher risk is inadequate. The ratio of reward to risk is far better at the lower risk end of the shares spectrum, such that regularly investing in the latter will produce a better long-term return than the higher reward but much higher risk end. They are not in proportion.

And what I mean by lower risk shares is, of course, value. But what I mean by higher risk is not just techs without earnings, penny shares and the like. It could well be large companies where the investor believes he can forecast years ahead. My belief is that there is huge risk in this. The chances of forecasting ten years of future earnings per share (EPS) in a row with as good an accuracy as 90% per year are only 35%. And nobody is going to get 90% accurate per year, so the likely chance gets down to nearly nothing. If your accuracy is 80% each year, still not bad, the chances of getting ten years right fall to only 11%.

What would you have to return in order to make a chance of 11% a profitable play? Answer: 100/11 equals 9. You would have to multiply your money nine times at least in ten years in order that the rewards outweigh the risk. Not very attractive. You may win by luck, of course, or you may have a "nose" for investments, in which case the odds are not really that low, they are swung in your favour by your nose. But for the noseless, the maths is against you. Yet this is what a large number of investors try to do.

The same principles are repeated in all sorts of investing styles. To me it makes no sense. It cannot. Just think of the dice. You play the game only if you can get better than 5-1. If you cannot, you don't play, except for a bit of fun, a little gamble. But not if we are talking professional gambling or professional investing that is trying to make real money.

I said above that what I meant by lower risk shares was value. But it does not have to be. It is my preferred method, but value is not the only approach that works. It can be any style where the investor believes that she can swing odds more in her favour than the market is in fact offering overall. To achieve a reward that is better, regularly, than the risks involved. But she has to believe that she really can do so, not merely dream as much. How does she know? Only one way – try it. But ensure it is repeatable. Anybody can get lucky. The only really effective strategies are those that continue to work over long periods, even despite some losses.

Some investors, for example, can win at trading highly volatile techs. Repeatedly winning far more than losing. They have the necessary, whatever that is. Those that don't, try to copy and lose out. They don't have the necessary. Critically, they don't understand that they don't have the necessary. They are envious of those that do and think it easy to emulate.

And the final truth. No repeatedly successful long-term investing style is easy, whether you try to emulate someone else's or formulate your own. Life just is not like that.

Where Next?

• Value investing discussion board