VALUE INVESTING
Back To The Roots

By Stephen Bland (TMFPyad)
March 8, 2002

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Stephen Bland on Value Investing

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Old hands can stop reading at this point because I'm going to do a bit of back-to-basics stuff.

It's the one about minimising the risks whilst maximising the rewards.

Investing involves an assessment of the potential rewards compared with the potential risks. Or at least it should do for those who are developing a strategy, although it may not for those still at the stage of following fads and tips, the latter frequently being a losing approach.

A winning approach requires that you minimise the risk/reward relationship so that you swing the odds of success more in your favour. It is also essential that this approach marries with your financial personality, or alternatively, that you change your personality to fit in with the approach, if you can.

This risk/reward ratio is not an actual number. In my view, t is not really possible to derive any sensible method of assessing quantitatively the potential rewards of a share strategy or its risks. So the ratio is more of an instinctive thing.

Looking at some examples, shares that have a single product business in some new technology for instance, are clearly at the very top of the risk spectrum. Against this, breweries, for example, tend to be low risk. Shares with enormous debt, whatever the business, are higher risk than shares without such burdens. And so on. The point is, that even without quantifying, it is fairly obvious that some areas are riskier than others.

Then consider the rewards. The single product new tech share may have massive potential reward but experience shows that only a very small proportion of such shares ever go on to perform in this manner. Large numbers of them will go bust or become near worthless penny stock plays. The brewery, on the other hand, is unlikely to show mega returns but probably will just chug away forever, producing a gentle but decent return over time in dividends and capital growth.

Clearly then, if you are tech share player for example, and this should be only because you think you have a feel for such shares (i.e. the strategy fits your personality), in order to follow risk/reward ratio minimisation you would need to find a way of trading off the massive individual risk in such shares. The obvious answer is to hold a large portfolio of them. In this way, you lower the total risk, the idea being that you hope to find a small number of tremendous performers over time that make up for the duds (and then some), in order to provide a good overall reward.

With value investing, we look first at the risk side of the ratio, in contrast to many other investors who often consider the potential reward first. Thus the idea is to start off asking how much might you lose if it goes wrong. This is the critical first step in the strategy, finding shares that minimise the downside long before you consider what upside they might present. This is done by restricting the initial search to cheap shares. Cheap doesn't mean low price, it means, for example, low price to earnings (P/E) ratios, high dividend yields, price to books (PBV) under 1. These are three of the most commonly used ratios used in share analysis.

The first two of those ratios, P/E and yield, can be relative to the market. My personal limits are a P/E of no more than 2/3rds of the market and a yield at least 50% over the market. So these are dynamic because they will alter with market levels. In practice, with the FTSE 100 on a P/E of around 20 and a yield of around 2.5%, the value shares which I consider will often be at far more attractive levels then my limits. Note though, that PBV is not relative, it is fixed. I will always look for a ratio of less than 1 on tangible assets for a deep value play.

The reason why cheap shares offer less risk than dear shares is that they are likely to fall far less if something goes wrong. A share on a P/E of 30 is expecting a lot in future growth. The slightest stumble in that growth and the market will trash it. You have no downside protection. But a share on a P/E of 7, trading below tangible book, expects little anyway. Bad news will have nowhere near the same impact on the share price as on the high P/E one. So with the cheaper share, we are buying protection and lowering the risk.

The value player in a way almost expects bad news, or at least is prepared for it. The problem is though that these cheap shares will, to a large extent, be cheap for a reason. So most of them are not worth buying. The trick is to find the cheap share that has strong upside potential thus maximising the risk/reward ratio. Next week, I'll revisit some of the pointers that can indicate growth possibilities.

This scrapyard mentality possibly explains why a cynical, curmudgeonly, opinionated attitude is so valuable to a value player. You have to believe you are right, you have to ignore press and analysts' opinions or use them contrarily because you are betting against them, against the market. They say this share is cheap for good reason. You say no. You have to believe that you are the only sane one in the asylum, that you really are Napoleon, whatever anyone tells you to the contrary.

Not tonight, Josephine.

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