VALUE INVESTING
Value Works

By Stephen Bland (TMFPyad)
June 4, 2004

Perhaps one of the shortest sentences I have written, barring those up with which I like to come up that have no verb. You can do that nowadays, write sentences without verbs, but you couldn't have when I was at school a millennia ago. Attitudes change. What was permissible in a previous time may no longer be so and vice versa.

Some things though never change, or at least not in the sort of timescale available to individual humans, namely their lifetime. Changes of an evolutionary nature are too lengthy to have a direct effect on our personal lives, fascinating though it is to learn about them. The particular feature I have in mind here is human nature with all its triumphs and failings. It has been the way it is for a very long time and will continue to be the way it is for a very long time, though I have no doubt that it will evolve into something higher eventually.

Our present state of mind is a mixture of the ancient and the modern. We still possess a lot of animal instincts combined with human consciousness that is very unanimal in character. What this present half-baked stage of human evolution leads to in my view is a bit of a split personality, whereby we are substantially rational in behaviour but we also have a fair streak of the irrational too. Animals are totally rational in an instinctive way, they don't think about it but in practice everything they do has a purpose. Humans are also animal-rational but because we in addition possess consciousness, that differentiates us from the average snail or whatever. This mixture is something with which we have not yet evolved to cope fully. It can lead us to act in the most irrational, pointless, vicious or just plain mad ways that, in contrast to animals, serve no purpose.

The stock market is a good example of the substantially rational yet partly irrational human behaviour pattern, with bubbles probably being the best example of the latter. Anyone with half a brain knows that buying bubble shares, unless you're smart enough to get out in time, will lead to large losses. Yet every time this happens, many naïve investors get burned. Why do they do it? Simple. Because everyone else is doing it. And for many people that is explanation enough. The herd instinct. Safety in numbers. Two of my verbless sentences.

Value says no. The real action, probably the only way for the small investor to make repeatable and decent profits over long periods is to do the precise opposite. Don't follow the herd, don't seek safety in numbers because usually it ain't there. On the contrary lead the herd. Find something cheap and good using fundamentals as the indicator, then wait, possibly for quite a long time if necessary. If the share continues to remain good, preferably even improves its fundamentals with rising profits, sooner or later others will notice this and drive up the price. Once this has happened sufficiently, get out.

It won't work every time, no share trading strategy can do that, but value is a wholly rational approach to share trading that creates sufficient opportunities so that even with the occasional loser, good profits can be made in the long term.

A common question is that, if it so obvious, why doesn't everyone do it? The answer is human nature again. Value shares are those by definition which are cheap. Many investors assume automatically, and wrongly, that cheap shares must have something awry with them. They are not comfortable with going out on a limb, leaving the herd. Yet you have to do this if you want to win.

Think about it, if someone offers you something which is very cheap, the common reaction is to be suspicious. Is it fake, is it nicked, is there something wrong with it? In most cases, the reaction is justified. But occasionally bargains do exist. If you write off everything that is cheap, you will miss them.

Many years ago my dad wanted to buy a car. He couldn't afford a new one so I helped him find something second hand. Instead of going to dealers we decided to have a look at cheaper private sales. He knew the particular model he wanted so we short listed a few from ads and went to see them. One in particular seemed a good buy, very low mileage, great condition. We liked it, started haggling and managed to push the already good price down a lot to an almost silly level. What was wrong with it? Nothing. It turned out that the guy worked in a foreign embassy and was being sent elsewhere in a few days, couldn't take the car with him and so had to get rid of it at any price. So cheap was it that someone my dad knew who dealt cars as a sideline immediately offered to buy it off him at a good profit, though he didn't sell.

My Value Investor newsletter aims to find you the share equivalent of that car. Cheap shares that are just too cheap for what they are. Using popular fundamentals like Price/Earnings, Yield, Price/Book and Net Cash, we search for shares that are trading cheaper than others but unreasonably so. Shares that the market has overlooked because too many investors believe that cheap shares are not worth examining or are too risky. The reverse is the case. By buying cheap, you minimise the downside. An already cheap share if it goes wrong, and some will, is likely to hurt you less than some sky-high over ramped fad stock that will collapse at the merest hint of things not being quite as hoped.

I called my approach, long before I started to write for The Motley Fool, PYAD. The acronym for P/E, Yield, Assets, Debt. These were the four key fundamental features which I seek. Generally a P/E at least one third below the market, a yield at least 50% above it, net tangible assets greater than the share price and no debt. A share exhibiting these characteristics is a pyad share and when combined with other attractive criteria such as rising eps forecasts, positive directors' comments, a good name and other points is very likely an attractive buy. However, full pyad shares are in practice too rare so that necessarily these criteria are loosened in various ways to produce value shares, but not as deep as the full pyad version.

In addition, the newsletter reviews a high yield share in each issue as part of a process of constructing a very long-term hold high yield portfolio for investors seeking income from equities or using this idea as a growth vehicle by reinvesting dividends. This idea, a cousin of value trading, follows on from the successful demonstration high yield portfolios I feature publicly on TMF that have beaten the market by a substantial margin. A large number of investors are uncomfortable with the idea of short-term trading but find that very long-term holding for income is rewarding and much more relaxed.

A special report into value shares that I have written about on TMF showed that these have produced an average gain of 60%, and this over a period when the market was falling for most of the time. You can access this report when you take a free trial to the newsletter. This is isn't being clever with hindsight, this is not backtesting, we're not saying that this would have happened had people done this or that, this is the result of what I actually wrote at the time. 51 shares produced a total return of 60% (i.e. including dividends) whilst over that time the All-Share index produced an average 10% fall on the same basis.

Note that there are some losers amongst all this. The gain of 60% is after deducting those. I stress this because value trading has to produce the occasional loss. Nobody should go into it unless they appreciate that this will happen to them at times.

As I said at the start, value works. I didn't invent it, I learned it from earlier successful investors and then added my own little tweaks that suit me. Others do likewise. Just about every successful investor has achieved that success via some version of value and yet the concept is pretty simple. KIS. Keep it Simple.

You've all heard of buy low, sell high. Obvious of course though few can actually put it into practice. How do you know what is low or high? Value is the embodiment of this principle. Our Value Investor newsletter has the facts. You can sign up for a free 30-day trail here.