VALUE INVESTING
The Logic Of Investing

By Stephen Bland (TMFPyad)
June 13, 2003

Whenever I consider the merits of a strategy and wish to comment upon it, one of the aspects I find it essential to consider is the logic of the approach. A strategy has to make sense.

Index tracker funds are widely promoted on this site as being suitable for many investors. Well, let's look at the logic. A FTSE100 tracker follows that index, which is constructed on wholly mechanical grounds. It is simply the 100 largest capitalised companies in the market, amended quarterly for changes. Note that so relatively large are these companies, compared to all other shares, that they represent around 80% of the capitalisation of the whole market.

A fund based on this index has to underperform it to some small extent and that underperformance will gradually worsen as it compounds over the lengthy periods for which it is advised to be held. Consequently, it can never beat the market nor even equal it. Does that matter? Well, not much in my view provided the ultimate return is healthy, by which I mean that it beats the return on cash by a good margin.

Is it risky? Yes of course, all equity investment is risky compared with cash. Critically though, trackers are far riskier than many perhaps thought in the past, as evidenced by what has happened to regular investors in trackers over the last few years. Five years was popularly supposed by some to be the minimum period after which you would be smiling. People now know what markets can do to shares when things get really rough.

One of the benefits of age is having seen it all before. There are precious few other benefits of age, I assure readers. Nobody listens though when you try and tell them of the risks at a point when times are good.

Do trackers have investment logic? Yes, I'd say they do. The concept of always holding the 100 largest companies makes some sense. Very long-term market returns are modest because the companies worth holding are severely diluted by all the rubbish. However, the rewards are a little ahead of cash, not really enough to justify the risks in my view, but for people who wish to be in equities and, for whatever reason, just will not consider any other approaches then they may suit.

Coming on to my favourite areas, but still with funds, I believe the equity income fund (EI) offers greater returns at lower risks. The investment logic is much stronger than a tracker because instead of buying the market the fund goes for a specific type of share that widespread evidence and history indicates is likely to have a far greater chance of long-term success than the market - the high yield share. Time and again, the evidence from many sources shows that a portfolio of high yield shares will outperform trackers.

The investment logic is twofold. Firstly, the higher yield than the market when reinvested automatically improves the return over the lower yield of a tracker fund. Secondly, higher yield shares are typically better value than the market because they may be unfairly depressed. Not all of course, but enough of them to give a boost to performance.

Not all EI funds are good however, and you have to be selective. I choose funds with consistently successful past records.

Following the same high yield logic, but much better than EI funds for long-term investors, are your own diversified high yield portfolios. No annual charges is one of the principal attractions here, but against that you need to be able to face selecting, buying and holding individual shares and dealing with decisions that arise occasionally when there may be a takeover or demerger etc., unlike a fund where it's all done for you. I believe that as well as leaving the market behind, such high yield portfolios will beat most EI funds as well.

Finally, for those prepared to trade more frequently, value shares of course. The logic is unassailable being, in a nutshell, buy cheap with good prospects. Like all trading strategies, it can't work every time but it will often enough to win. Although it will not suit the majority of equity investors, you can read about it here.

Finally finally, a word on popular approaches that have no logic. I was reading somewhere about a guy who had claimed to do well using astrology. As most of us know, astrology is complete bunk and cannot have any investment or any other logic come to that, but nevertheless I wanted to know what he was doing. Turns out he was simply using typical value ideas and the astrology was just a superficial layer. He went for the usual value basis of finding shares, which was likely to work anyway, but claimed to improve performance by considering in addition some astrological factors. A likely story.

Another logicless approach is the net present value method supposed by the naïve to be practised by Warren Buffett, but which I very much doubt is the case. This attempts to arrive at a theoretical current price of a share by discounting long term future profits or cash flows or dividends, the theory being that the current "correct" price of a share is supposed to be that NPV. Consequently, if the actual price is well below the NPV figure, the share is attractive. Perhaps the biggest load of tosh ever foisted on investors using fundamental analysis, I'm sure this has resulted in substantial losses for many people trying to emulate Mr Buffett. This style appears to possess logic. But in practice it cannot. The reason is the complete unpredictability of long-term corporate futures. Even in the short term, it goes wrong too often. I would rather use astrology.

I won't mention pure technical analysis, which comes somewhere below astrology in its possession of investment logic, but it hurts me how many people on this site alone seem to think that it has some use, despite conspicuous absence of its proponents from the ranks of serious winners. I suggest followers effect a dramatic improvement in their hit rate by an immediate switch to astrology.