VALUE INVESTING
Not Today Dear

By Stephen Bland (TMFPyad)
November 9, 2001

Some basic comment today, aimed at the beginner to investing and not the experienced old curmudgeons that haunt the value board.

Risk, the theoretical discussion of, is a favourite topic of mine. I enjoy games of risk like poker for example. Not pure chance casino games like roulette where you can't beat the clear odds in the long run, but those where you can exercise some influence over your destiny so as to try and improve the math in your favour. Put another way, games where there is an element of chance but also an element of skill, not just a straight gamble.

Investing is one such game I think, I mean one of risk but where you can try and improve the odds in your favour. Yet many investors do not even attempt to do so, lacking any strategy and investing on a whim or tip. It is clear from even an elementary study of the stock market that certain types of shares exhibit lower risk than others. That is they have more chance of going up than down over time. No guarantees, we are looking only at likelihoods here not certainties. Remember the idea is to improve the chances in your favour, lower the risk if you like, but you cannot eliminate it entirely with shares.

The first rule above all is to minimise the downside, which could also be expressed as don't lose money. All shares involve the risk of this happening of course, you can't avoid it, but you can develop some personal rules that will minimise the chances of it. Don't buy shares that have serious downside potential, critically, and this is where many investors go wrong, even if they appear to have serious upside as well. Forget the upside at first, concentrate on finding shares that stand the best chance of avoiding losses. Then from amongst those, filter out the ones that look to have the best potential for gain.

One clear method that value players always use for minimising the downside is never buy dear. You simply rule out of your potential pool of shares anything that costs over a certain level as judged by combinations of fundamentals like P/E, yield, Price/Book, debt levels or whatever pet features you choose. There are a large number that can be so utilised.

Judging by studies such as O'Shaughnessy's book "What Works On Wall Street", you have immediately improved your chances of making money from shares simply by concentrating on the cheaper end of the market, even before considering anything as crude as what the company actually does for a living.

Following on from this I will never understand why anybody ever buys dear shares. Yes you can make money from dear shares but only if you are a skilled trader, or alternatively hitting on very high growth stocks which continue to deliver that growth over long periods, which immediately rules out nearly all small amateur investors that tend to possess neither of these abilities. So, on the assumption that you don't possess good trader instincts or a nose for sustained growth shares, there is no reason to buy dear shares -- ever. If you are a fundamentalist, always concentrate your search amongst that proportion of the market selling at relatively much cheaper levels than average on your favourite criteria. By so doing you have immediately tilted the odds in your favour.

And yet you still see the old rubbish trotted out by some commentators - "Dichotomy is a great investment on a P/E of only a 100. Eps will grow at such a rate that today's price will seem cheap in few years"

Sure. As if anyone has the faintest idea of what will happen in a few years. The share may prove the bargain of the century of course but why should any rational investor take such a long shot? It is utter folly. Pointing to shares that did in the past go on to do this is meaningless because for every one that did so there will be a large number that failed.

The only way to play that game is to hold a very large number of such shares and possess a nose for it but typically such investors will not. They do not understand the odds or if they do are simply just gamblers and not good investors. Holding five or ten expensive shares in the hope of finding a huge winner is inadequate. The incidence of such success is way lower than one in five or ten. Consequently such investors are very likely to lose overall. There are a tiny number of very skilled investors that do have the knack of picking such winners but not the average small player at whom I aiming this article.

The conclusion must be that for most small investors seeking some sort of fundamental strategy, and only a dedicated strategy of any sort is likely to deliver long term repeated success in the stock market, that you start by ignoring a very large part of the market – the dear part.