VALUE INVESTING
Why Value?

By Stephen Bland (TMFPyad)
March 18, 2005

I could answer by saying Why Not Value? Old hands will know what I mean, however such sophistry hardly answers the title question for a beginner.

In Value Investor, my monthly subscription newsletter, we select two value trading shares each month plus a long-term hold high yield share. It is perfectly reasonable for people, beginners particularly, to ask what exactly is attractive about value shares and why they are a preferred trading approach compared with the many others out there. Since I am selling the idea I have to come up with plausible answers.

In recent articles, I have outlined the quintessential technicalities of the strategy. These are concerned with firstly minimising the downside and secondly maximising the upside through the use of a series of popular fundamental ratios and facts about a share. Although these spell out the methodology of the approach they may not tell the whole story of its success. It is one thing to explain the mechanics of a trading strategy but that alone does not necessarily tell you why it ought to score. I am writing here about the necessity for investment logic to be present in any strategy.

One thing which characterises successful traders in anything is the ability to buy cheap. Far more important than selling dear is the process of locating the cheapest possible source of the items they trade. This is because they can't do much about the selling price, it is dictated by the market, so that the only way to increase the margin is to buy cheaper than others, perhaps by seeing an opportunity that others miss. Unusually cheap items don't appear that often, they wouldn't be unusually cheap otherwise, but spotting these can be the key to much bigger profits than the average trader. Value Investor aims to find these unusually cheap shares in the stock market.

I've seen this with something as crude as second hand cars. A lot of these come through the trade to dealers as part exchanges and consequently they are bought at a trade market price which the dealer marks up for his sale. But by buying privately and then selling on as a dealer to the public, far greater margins can sometimes be obtained. Privately sold car are cheaper than dealers anyway but sometimes the price can be pushed down much further than that. It requires work, travelling the country seeking out those special buys, but it can be very rewarding.

The same goes with value shares. They require work and they work because they are bought for trading at a much lower rating than many other shares. Not because there is something wrong with them but simply because they are mispriced in the investor's opinion, though not that of the market. This is the key to the whole approach. Value works because it finds shares that are too cheap. Very similar to any other successful trading business.

This is what I mean by investment logic. It is clear that if you can buy something which you believe to be very cheap compared with the market, then you have a good chance later on of being able to sell it dearer. Additionally, you have a lesser chance of it going seriously wrong because it was already cheap in the first place. Compare this logic with that of buying average or dear shares. The latter may rise but in general they do not have as much potential scope to do so as value shares. For me, dear shares lack investment logic as much as cheap value shares possess it.

Note that this investment logic is quite irrespective of the mechanics of the approach. Even if you didn't know how to do it, the logic itself is unassailable. What remains is to work out the numerical or other data which indicates how to operate the process and that is what I have been describing in recent weeks.

Value Investor uses exactly this logic and process to discover shares for readers. The next issue is out later today. You can sign up here for 30-day free trial.