VALUE INVESTING
Strategies That Win In The Stock Market

By Stephen Bland (TMFPyad)
October 24, 2003

People sometimes describe shares as "equities" or talk about having "equity" in a property but what exactly does this word mean? It means having no fixed return. In contrast, loan investments carry some kind of known and frequently secured return to the investor.

A company will be financed by its owners, the shareholders, and may have loan capital as well, the origin of the description "joint stock company", as companies used to be known long ago. Similarly, a property may have a mortgage owned by a bank. The balance of its value is the equity due to the owner. In the case of both the company and the property, the loan holder is by far the lower risk taker because of the fixed return and the security of the debt. The equity holder carries substantially the most risk but also has potentially unlimited reward or, in the worst case, a potentially total loss.

Elementary stuff. My point is though that on the face of it equity represents an enormously attractive investment, precisely because of its capability for unlimited return. This capability does though, in my opinion, over rate equities as an investment, giving them an unwarranted reputation for making a lot of money quickly. I say this because I believe that a large number of small investors in the market lose money or make very little in return for their risks, particularly those that try and dabble.

Despite the highly attractive potential for unlimited return suggested by the very name of "equity", very few small investors ever make much money in the stock market. Too many will lose money and some may make a little but no more than they might have obtained risk free elsewhere. A few will do moderately well and justify the whole thing. But hardly any will ever make the sort of life changing sums worthy of the term "serious." I am concerned here though not with the serious but with those doing moderately well. You can't emulate the stars because you don't have what it takes. However, you may well be able to emulate those who have done quite nicely by adopting the right approach.

I have known a lot of equity investors  in my life but only two of them ever scored big time in shares. One of those almost went broke in the end. The other was so successful that he moved to Jersey. Anyone who knows anything about Jersey will know what that means. Being just so-so rich isn't enough to be allowed in.

Some more did quite well, not life changing, but well enough to justify the risks they were running. Most lost in the end or made little and would have done better with a deposit account at no risk. All anecdotal but I believe this probably overstates the success rate, because I tended to know some quite skilled individuals. The fact is that I have known far more people do better in property over long periods than in shares.

What I am getting at here is that it is not easy to do well in shares. It is probably much harder than that favourite British investment activity – property. In practice it seems to me that shares are an area of investment at which few small investors will be even moderately successful and it is those with whom I am concerned here. Who will they be?

Well, it's boring and requires extreme patience, but a great proportion of them will be simple long term buy and hold value investors. They'll invest in high yield shares and reinvest their dividends. This to me is possibly the greatest strategy of all for the investor who does not possess trading skills of any kind - which is far and away the great majority of people. The high yield player will in the end leave nearly everyone else behind in my view, even if it takes many years.

Next we have those with some trading skills – a very small minority and a mere fraction of those fools who think they have some skill at this, maybe because they struck lucky at first. Value shares are my chosen trading strategy because this fits my personality but there are many other styles and some people are just natural traders anyway. If you don't know whether you possess trading skills, you'll soon find out the hard way. For too many though, regular trading does not work out sufficiently well to justify the effort and risk involved. But if you've got such skills then fine.

Some long-term fund investors may do moderately well. Trackers are often mentioned around The Motley Fool and are the best option for those who do not wish to take any interest at all in the market. For those that do take an interest, I think UK equity income funds are an attractive alternative. I believe that many of these - but by no means all - produce a better return than trackers with lower risk. It is the holy grail of investing to do better than the market and with lower risk but that seems to be what these funds offer. The reason is that this is just another twist on the high yield idea, a well known route to long-term stock market nirvana.

In conclusion, my view, as you might expect, is that it is the value-based strategies which deliver the greatest likelihood of success in the stock market, a market in which it is pretty hard to excel at using any style. The logic is so simple. Buying cheap is really just the basis of it.