VALUE INVESTING
Independent Insurance & the Limits of Value

By Stephen Bland (TMFPyad)
June 22, 2001

There were no shares about which I thought it worth writing this week, so time for some reflection. The collapse of Independent Insurance (LSE: IIG), with the likely total loss of investors' money, was a sad reminder of how even ostensibly attractive value plays can go completely wrong.

Value shares are supposed to be much safer than shares in general because of the low ratings of their fundamentals, the idea being twofold. Firstly, to offer protection against just such an occurrence as with Independent; and secondly, precisely because the fundamentals are cheap, the opportunity for the share to rise driven by some factor perceived by the investor that is not yet recognised in the price: usually rising forecast earnings per share, though there can on occasion be different reasons that make the share attractive.

Despite the failure of Independent I personally continue to have complete faith in the value approach. It was never the case, anyway, that all value investments are successful, although losing the lot like this is extremely rare, especially in a company that was not a small cap. It is only necessary that your winners make far more than your losers, so that over time you end up well ahead, for the strategy to be a success. Easy for me to say I guess because I wasn't in Independent. This is not the first time a value share has gone bust, and it may not be the last either. It's one of the risks of investing in shares generally.

Understandably there has been a series of post mortems on the value board regarding Independent because it had been discussed such a lot previously and many of the regulars there seem to have held the share. Apart from regrets at losing all their money held in this share, readers naturally are looking for some ways to protect against this kind of thing in future.

It hadn't helped that I had written an article on it a while back though I never went in myself. I will admit to giving it a pretty close scroot but at the end of the day it just wasn't attractive enough for me. But I am ultra conservative, hardly any shares, any value shares, ever appeal to me sufficiently that I am willing to get out my wallet. I have to be this way because I eschew the portfolio approach in favour of making a few large investments, often only one. A style which is totally insane and in consequence should not be followed by anyone else.

Why didn't I buy Independent? It's a question I have asked myself. It was pretty attractive and I have nothing against insurance companies. Indeed they have been very good to me in the past and I will not hesitate to invest in the sector again should the right share come along. I guess Independent probably just didn't smell right but that is difficult to put into hard evidence.

Looking back over my article and trying to recall what was going through my mind, not just when researching the article but when actively considering going in and trying to recall what stopped me, the only little clue I can find is that past optimistic directors' forecasts had gone wrong when the actual results came out. This did not exactly encourage faith in the board, to put it mildly. This point is the only tangible evidence I can find for my own reluctance. Personally I set great importance upon directors' comments about the likely direction of the company, so if they have demonstrated optimism on previous occasions that later turned out to have been unwarranted, that is a clear turn-off. Not that it takes much to turn me off a share anyway; a small signal like this is quite enough.

People now, with hindsight, see many different reasons why they should not have invested but little of this was apparent at the time or is much help in future protection. Some have said they will never buy insurance shares again but I can't agree with this having done well out of them on more than one occasion. Whatever the reasons for the company going under, I suspect they are probably unique to it and teach us little about how to avoid this kind of thing again.

A clear problem with using certain fundamental ratios as an investment tool is that they are based only on the latest published accounts or later news and forecasts. Consequently they are always going to be historical or somebody's opinion. It follows that if there has been some sizeable adverse change in the company's figures since the data used by the investor was compiled, then the basis for the investment will be flawed.

Now value tries to protect against too serious a loss in such a situation by minimising the downside, by limiting the damage. A share that already has a low rating in the market should not fall by a catastrophic amount, usually, even if earnings per share collapse for example. In any event such a negative surprise will have a far lesser impact on a value share than on a highly rated one. But when, very rarely, the sizeable change in the figures to which I refer above is of such an order of magnitude that it is sufficient to drive the company under, even the value downside minimisation factors cannot protect you.

More: Independent Insurance Group discussion board