VALUE INVESTING
The Price Is Wrong

By Stephen Bland (TMFPyad)
May 2, 2003

I guess it is very common for many private investors, whatever strategy they use, to compare the current share price with their entry price. This is a completely natural inclination with a clear purpose, the obvious one of telling you whether you are showing a profit or a loss. Of course, you will not last too long if you make more losses than profits on your trades. Whatever strategy you use though, you must be prepared to accept some losses.

With value, my view is that the investor should try and ignore the purchase price. They should sever that link in their mind between cost and current price. This is extremely difficult to do in practice because it is counter-intuitive. Automatically, when you look at today's price of your share, your mind does some crude maths to indicate what you are making or losing. The result of this is probably either elation or depression -- emotions that are undesirable with investing.

Imagine that immediately upon buying your value share, you suffer a bout of temporary amnesia regarding the purchase price. Whenever you look at the price in future, you therefore have no idea of what you paid and consequently of whether you are showing a profit or a loss, and thus have no particular reason to be elated or depressed. With such sentiments stripped away, you now have no choice as a value player but to reassess continually whether the share displays the required elements of your value features that cause you either to hang on or sell.

Sooner or later, you will sell because it has breached your selling fundamentals criteria, perhaps with the aid of other classic value sell signals like widespread press tipping for example. But the decision, due to your cost amnesia, has been taken entirely independently of the price paid and therefore independently of whether you are showing a profit or loss. It is made purely on whether the current valuation and circumstances merit a sell.

At that point, having closed the trade, miraculously you recover your memory and discover how you did. This would be the absolute ideal way to play value (and many other strategies, too). It involves playing exactly according to your plan rules. If the plan is valid, you must win overall on your trades, even with some losses. If it still went wrong too often, then it would be the strategy that was at fault, not your emotions.

This would be trading nirvana, if only you could forget that bugbear of the trader, purchase price. But you can't of course. After doing this for thirty years, I can't either. But I have got to the stage where I am not afraid to take a hit on a loss-maker if I believe that the fundamentals have evaporated sufficiently to the point where I no longer wish to hold the share. Make no mistake, it still hurts, but I'll do it anyway. Equally, I will not sell a share just because it is showing a decent profit if I believe that it still possesses sufficient value to justify holding.

Clearly, mistakes can be made. Or what appear to be mistakes with hindsight anyway. A share that is losing might recover even though I get out because I consider it does not possess sufficient value any longer. A share that is winning might fall back even though I think it still has some mileage left in it. Both these cases have occurred a number of times in my value career. But it is a question of likelihoods based on my experience.

These are not really mistakes but trades made according to my rules. Rules which cannot be perfect and therefore will sometimes produce lower profits, or some loss, than holding for emotional reasons. Nevertheless, I believe these rules will give me the best chance in the long run of making decent profits with the least risk. The latter point is critical to a value strategy; I don't want to be in a share where I consider it is too risky to continue holding.

Sounds easy, but all you have to do is ask yourself regularly about a share you are holding and whether it still suits your particular value criteria, including peripheral features like press comment etc. Does it justify continued holding irrespective of purchase price? Hold if it does, sell if it doesn't. Not always that easy in practice I should add.

Trying to avoid permitting a sell decision to be influenced by purchase price is something which value investors should try and develop. It is very liberating but, like anything worth having, quite difficult to achieve. You cannot get to the position of the amnesiac but you can learn to shrug your shoulders at a poor trade, fail to get too excited by a good one and just move on to the next deal. This situation is helped by one of my annoying little aphorisms: Never look back.