VALUE INVESTING
Value and Risk

By Stephen Bland (TMFPyad)
February 9, 2001

I couldn't find any company about which I felt motivated enough to write about this week, so I thought I would simply bore everyone and return to one of my favourite themes -- risk, and its relationship with the art of value investing.

I guess that anyone reading this probably needs little introduction to what I define as value investing. However if anyone is not sure, to make this clear, for me the term "value" refers specifically to shares trading on fundamentals at a large discount to the market.

Defining risk, though, insofar as it applies to equity investing, is not quite so obvious. A lot of commentators equate risk with volatility and it is indeed one definition which I accept. Here's why: simple, really. The more volatile an investment, the less its predictable worth at any future point, and hence the more risk you take on.

A sum of money in a deposit account earning a fixed rate of interest has a 100% predictable value at any point, ignoring the risk of the source going bust. No volatility equals zero risk. You can see that this lack of risk is indicated by the predictable future worth of the investment.

Contrast this with a share. The price at any future point cannot be determined with any accuracy. It may be more or less than the start money. It is thus possesses volatility and, in consequence, risk. The degree of risk may vary from share to share but they all possess this characteristic to some degree. By not knowing what the future holds, risk is introduced.

It follows that people who invest in shares (as distinct from deposit accounts), knowing what I have said above, actually court risk. They desire it. Now why would anybody desire risk, when there are risk-free situations like deposits available? Clearly to try and generate a greater return than cash.

Are some shares riskier than others? Well, answers may vary. But every value player worthy of the name must answer "yes". Because the cornerstone of the value game is to try and find shares that possess minimum downside whilst at the same time possessing substantial upside: the magic formula. Put another way, it is trying to turn the odds of winning in your favour as much as is possible in a situation such as equities, where you cannot eliminate risk but you can reduce it.

The reason that many people lose money in shares is that they do not consider the risk. They do not ask themselves before buying: what can go wrong? They do not play the odds. A mistake, in my view, because the first step towards making money in the market is not losing it, whatever the style of play.

Buying shares that have a large downside potential increases your risk dramatically. A share on a very high P/E, for example, can be trashed on the slightest whiff of bad news. This can be seen in the market with monotonous regularity. Sometimes the news is hardly bad at all. A mere slight reduction in a formerly outstanding growth rate can be enough. The remaining growth rate may still be something many companies would kill for, yet such news can destroy a high flying growth share. This phenomenon is so common that I wonder why many people ever buy such shares although I know the answer already of course. The herd instinct is very powerful. Everybody is buying a share therefore there is comfort in me buying it too. Even in the face of the evidence of the enormous graveyard of former highly rated shares. The market punishes nothing as much as a fallen high flyer.

I am not saying you cannot make money in such shares. I have known people do this very successfully, but it is difficult. You have to know when to get out: while the share is still rising, leaving something for the next guy, being prepared in consequence to give up the chance of finding the next Microsoft in return for making a much lower but much more likely profit, because a very large proportion of rapid growth shares eventually get hit. But as far as I have seen, few small investors possess this instinct. A lot fewer than those who attempt it.

Value seems to offer the best of all worlds: lower risk than many shares, with often decent rewards. It can be seen as quite boring though. Nothing may happen for some time as you wait to find the right shares. Having found them, you then have to hang around until the value is outed, which can take an even longer time. A lot of investors just don't have the patience, or the belief in themselves, to do this properly. It is not easy to buy shares that are portrayed by the market as poor investments by virtue of their low ratings. It is not easy to buy shares that analysts and press tipsters counsel against in their recommendations.

Many years ago I was a herd follower and after many deals found I was losing money. I decided to change my outlook to the exact opposite. I forced myself to look at shares in which nobody was interested, to shun those in which everybody was interested. Scary to start with, because going against the mob lacks allies, friends, which most of us desire in life. It is very lonely. Unnatural at first, this way of looking at things eventually became my primary financial nature. Now what bothers me is doing the same as everyone else and I am comfortable only in shares that are cheap because others are not interested. I now feel uncomfortable in the very situations in which most others find comfort: that is, popular shares.

Where Next?

Value shares discussion board
Investment Strategies discussion board