VALUE INVESTING
Breaking The Rules

By Stephen Bland (TMFPyad)
November 29, 2002

I have never been one to observe too many of what are perceived as common investment rules, apart from ones that I made up for myself of course and even those I may bend on occasion. Some of these concepts have become the clichés of TMF message boards to the point of nausea and I suspect that they are most frequently repeated by those with the least experience of the market.

Here are two of these rules and why I disagree with them as a value investor.

Run your winners, cut your losses

I have never understood this, even though I first heard it before most TMF readers were even born I expect. What does it mean exactly? How do you know how far a winner is going to run? How do you know that a loss maker won't recover?

You buy a value share. You get it right and it rises strongly in a shortish time. My rule says sell when sufficient value has evaporated which will be too soon for some but I prefer to leave something for the next guy. I don't want to hold a share that no longer represents what I believe makes a share attractive and where the risks as I see them have in consequence multiplied against the potential reward. I'm only interested in that first really chunky bit of outing because it is carried out at minimum risk.

A winner that is being run, for no reason other than it's a winner with no fundamental justification, is quite liable to turn bad on you suddenly. By not leaving something for the next guy you end up becoming the next guy.

The same applies to cutting losses. I cut a loss because too much value has gone, or occasionally perhaps because an achingly desirable alternative opportunity has suddenly dropped in your lap. But I am unlikely to sell a value share purely because it is showing a loss which I perceive as mere noise. Loads of shares that I have owned have fallen at first for no fundamental reasons then gone on to score big time. If I'd sold them all when they were showing a loss, for that reason alone, I probably would have given up on shares altogether and kept my wad, if I'd still had any after I'd listened to this nonsense and "cut my losses," in the Old Farts Mutual Building Society

Never catch a falling knife, falling off cliffs etc., falling anywhere in general

Another load of nonsense from the cliché factory of which we've heard far too much in the bear market. What this suggests is that you should not buy a share where the price has been falling rapidly, even though it may possess good fundies. How do you know when it has stopped falling? You don't and if you wait for the upturn you may miss it. A share that has value must stop falling and will reverse, often making very good and rapid early profits in a turn round situation. Those that wait for the upturn to be confirmed can easily miss out on that. And waiting for an upturn can catch you out because that upturn may just be a blip in a further fall The risk of course is that it continues falling but nobody ever said investing, particularly for the short term, is without risk. If you are going to buy the share you will have to make a decision at some point but I personally don't believe in waiting for it to start rising.

The psychology of falling shares is interesting. All value and contrarian players should familiarise themselves with a little investment psychology. The tendency is for people to think that a trend will continue. It's similar to what I've called Recent Events Syndrome whereby many investors go wrong by overweighting recent events when making decisions compared with past ones or long term historical truths. Use this to your advantage.

I recall being at a home game of Brentford a few years ago when they defeated Cambridge United by 6-1 or something. Believe me when I say this was not exactly a common occurrence for Brentford. The following home game, at the bookies inside the ground, I observed some mug Bees fans betting on superficially attractive odds that the home side would again score 6 just because it happened last time and ignoring one hundred years of history. In a share, or market, that has fallen a lot, most commentators will believe that it will fall further. They will always find reasons to justify this. Learn to sense when this belief is overpoweringly prevalent combined with screamingly attractive fundies. Then do the opposite. Such a moment occurred a few weeks ago with bank and insurance shares since when tremendous rises have occurred. The knife was ready to be caught but not by those who spout this tired doctrine as though it is some eternal truth.

My general point is that I believe it is only possible to make repeated and substantial short term profits over a long period by being a contrarian in some way. Following clichés, by definition, is hardly going to ensure that you are doing much different to the crowd.