VALUE INVESTING
The Rational Way

By Stephen Bland (TMFPyad)
April 19, 2002

Why do people buy certain shares that are clearly riskier than some other shares without trying to protect themselves against that higher risk? Because investors are not always wholly rational.

If you treat investment as an outright gamble you will probably lose in the long run, in the same way that most horse, casino or lottery punters will lose. Now this might be okay if it is being done for small stakes only and the whole thing is seen merely as a kind of entertainment. But it is not serious investment. However people will usually invest much larger sums in shares and if they do so without some kind of strategy that attempts to minimise the risks and maximise the rewards they are creating an automatic disadvantage for themselves from the start.

There are many share strategies that offer lower risk with the chance of decent rewards. I believe that literal long-term hold for instance does this, though it may not be too exciting. Here we have the chance that in the long run a diversified portfolio of blue chips will do reasonably well simply by sitting on them for a very long time, reinvesting dividends if you don't need them. It is hoped that the lengthy time element compensates for the risk of inevitable short term fluctuations by providing long term growth.

On the other hand if you like small tech companies, which are high risk individually, then the answer to the risk question is to hold a large portfolio of these, trading off the individual risk, knowing that most will do poorly, against the hope that one or two of them might do very well.

Whatever your strategy, you should always aim to minimise the risk/reward ratio if you are a serious investor, not merely a punter. It is not rational to do anything else. Unfortunately it appears to me that a lot of small investors are simply not rational. They don't plan their investing. They are like the small gambler backing hunches or tips without judging risk, unlike the more professional gambler who tries to measure the risk and goes in only when he perceives the odds against him to be as low as possible. Strategy players resemble the professional gamblers in a way.

Value shares offer a way of minimising this ratio. Built into the approach is the search for cheap shares which because they are already cheap, are less likely to become too much cheaper still even if something goes wrong with them. You are looking to protect yourself from loss as far as possible. The first step to winning is avoiding losing. Then from this pool of cheap shares are selected those which appear to offer decent upside.

In practice it may be even simpler than that. Provided you hold a wide portfolio of deep value shares, it may be sufficient to ignore any upside features like rising eps and so on. Very deep value shares sometimes have a habit of rising in any case without an obvious outer, because they are little more than asset plays which some predators find attractive. The deep value, particularly ultra low P/TBV and without debt, is itself the outer. To play it this way though, without looking for rising eps, you would be advised to hold as large a portfolio as you can assemble, because not all the shares will do well. Those like me who wish to hold only a few good value shares will normally require rising eps or at least a good smell about the company. Note that both the above value styles pay careful attention to the risk/reward ratio.

Whatever approach you follow for share investing, it will not make sense in the long run for you to take bigger risks than necessary to achieve profits. But too many people seem to do just this. Look to minimise the risks and maximise the rewards.