VALUE INVESTING
Why Buy Dear?

By Stephen Bland (TMFPyad)
June 14, 2002

Some beginner's basics today. Weary and experienced old hands need not read further.

One simple way to analyse the whole stock market is to rank shares by any measure of their expense, using popular fundamental ratios such as price earnings ratio (P/E) or dividend yield for example, although that would exclude shares making losses or not paying dividends. Ignoring the latter point though, you would derive a view of every share compared to its peers and to the market average. Any particular share could then on this basis be judged cheap or dear.

Note that this is only relative, there is no permanent, fixed or absolute P/E or yield against which to judge shares. A P/E of say 15 is on the cheap side if the market is at 25 but would be dear if the market goes to 12. You could make a similar point relative to the share's sector. The market average will fluctuate over time so that what appears cheap at one point might appear dear on another occasion. We have seen over the last couple of years a falling market and in the last few days a rapidly falling one. This will lower the market P/E and raise its yield assuming the earnings and dividends of the shares concerned are more or less constant.

But whatever the prevailing averages, it remains true that at any point you can carry out this ranking to analyse the cheap from the dear. If you rank by descending P/E then for value investors, the interesting shares would be those around the bottom of the list. If you list by descending yield then those around the top are where any search would be concentrated.

All fairly obvious. But what might not be so obvious to the uninitiated is why these cheap shares are more attractive than the dear ones. After all cheap shares are cheap for a reason, no? No! At least not always.

Supposing you were totally unselective, other than choosing two portfolios of equal numbers of shares, a cheap one having low P/E plus high yield, and a dear one with high P/E plus low yield but doing in both cases no further research as to the quality of these companies. You then sit on these for a long time. The likelihood is that the cheap portfolio will outperform the dear one by a large margin and moreover beat the market as well. This is a very simple strategy and to make it work the portfolio would require a decent number of shares to allow for the likely duds that would appear. Say 15 shares at least plus a lot of patience.

The question though is why does this work? The principal reason is psychology, or good old reliable human nature. When the market decides a share is down, it really kicks it. And on the contrary when the market feels a share is motoring it tends to boost it way out of any sensible valuation, making it highly susceptible to the slightest setback in earnings or just plain adverse sentiment. So by purchasing a random group of cheap shares, you will likely be buying a lot that are oversold. In time this corrects. Similarly by buying a group of dear shares, you are likely going into a largely overbought situation. In time this corrects – the wrong way. No guarantees of course, these are just likelihoods not certainties.

But given this tendency, for the long term portfolio investor, I repeat my title question: Why buy dear? It makes no sense at all in most cases. Yet people still do it. Don't be one of them. Stick to the cheap, the value end of the market, even if you are not an out and out short term value player like myself but just a buy and hold investor. It means going against the trend, against the fashions. But that is where the money is. Always do this kind of simple analysis if you are building portfolios to hold and don't be swayed by press comment or tips etc.

The experience of the last few years with the collapse of highly rated techs and the like is not unusual. It is normal. I have seen it time and again. In the long run cheap wins every time and dear loses.