VALUE INVESTING
Maximising The Upside

By Stephen Bland (TMFPyad)
March 15, 2002

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Old hands can stop reading at this point because I'm going to do a bit more of the back-to-basics stuff. Following on from last week's revisiting of minimising the downside, this is the one about maximising the upside.

The order of these articles is no accident. With value shares, like sex, protection comes first then the pleasurable bit. Thus above all when seeking suitable value plays, you must first identify those shares that have in your view the minimum of downside risk using the sort of approach I outlined last week.  From that pool, and only from that pool, should you then select those shares that you believe are due for a rise at some point. By this process you will achieve as much downside protection as possible combined with as much upside potential as you can find.

Psychologically, this approach of safety first might appear the wrong way round for the inexperienced or non-value style investor. Generally, when you read or hear somewhere about specific shares the main point that will be promoted is all the wonderful potential of the company. It's got some great new product, great management, business is booming in its sector and so on. Rarely will people commenting favourably on specific shares start with what can go wrong, it is nearly always a focus on the perceived good points alone, which can give the impression to the unwary that it is almost a sure thing.

For value investing, caution rules.

The most common feature to look for that will likely cause a value share to increase, that is the factor which will out the value, is rising forecast earnings per share. If a value share is standing on a historical P/E of say 8, with eps forecast to rise 20%, then its forecast P/E drops to 6.7. Thus immediately it will become even cheaper on a P/E basis unless the price goes up in due course. That rise in eps is what may drive up the price. Clearly in order to simply maintain the same P/E of 8, the price must rise 20%. If you are lucky though, the market may re-rate the share, perhaps deciding in its fickle way that it was not such a load of wossitsname after all, and in consequence give it a P/E of 10 on the new eps. If that happens, then you are looking at a price rise of 50% over the original figure, perhaps during a year as the new eps becomes known. Over that time, whilst waiting for the share to work, you will in addition have earned dividends, probably yielding more than you could have got in the bank.

The primary risk of course is that the forecast eps rise will not materialise. Analysts' forecasts are notoriously unreliable. But if that happens then we have downside protection, remember? Negative eps surprises will in general not have too dramatic an effect on deep value share prices. I'm not saying they are exactly good for you, but if it happens, and it will sometimes because that is the risk you have to take, then the hit is likely to be a mere fraction of that which happens in the case of high P/E shares faltering in anticipated eps.

There are other outing factors. A deep discount to tangible book value can sometimes alone be attractive even if the company is loss making. This would depend completely on the nature of the assets, cash, listed investments and property generally being the most attractive. To establish this I would advise careful study of the accounts, particularly in the case of property assets, because there is property and then again there is property. Look for development potential.

Yield alone is not an attractive outer for a value play, even if high, because a company can cut its dividend at will. I see yield as a sweetener, something to keep me happy whilst waiting for the share to do the business for me. Some value players are prepared to forego all yield for a good investment, but I will rarely do that. It is one less bit of protection and shares are risky enough as it is. The more defences you can build the better.

Unfortunately if you build them too strong you will never find any suitable plays, so some sort of compromise is inevitable. How strong a barricade you put up against the downside depends on how you wish to play the game.

And if you can't find any shares from your downside minimised pool that do not display upside that you find attractive? Stay out of the market. As a value player, never feel that you have to be invested. Cash can be a fine value share for quite long periods. Be patient, wait for your targets to arise, then go in only when you perceive the odds are in your favour, according to your version of the strategy.