VALUE INVESTING
When Value Goes Wrong

By Stephen Bland (TMFPyad)
November 25, 2005

Sometimes, an ostensibly attractive value share goes completely wrong, may even go bust in the worst case. The question is whether the value investor can detect the signs of this prior to purchase and thus avoid losing money.

There is no prophylactic of which I am aware that will obviate the risk of losing money occasionally for those that buy shares in order to trade them short term. Shares are risk investments and thus by definition that risk will work against the investor at times whatever the approach. Although to some naïve beginners, risk investments might, especially in certain boom periods, seem like something which appear only to rise, that can never be the real situation in the end.

Once you engage in trading shares regularly and do so over a long period, you have to accept that it will go wrong sometimes. You accept that, in return for the hope that it will go right much more often than it will go wrong, making on balance decent profits over a long series of trades.

Value already carries with it the methods to lower risk as much as possible. My approach actually started off a long time ago by first minimising the downside. I saw the first step to making money as not losing it, or at least limiting that risk. So long before I started wondering what circumstances might drive a share up, I set criteria, the pyad features, which I regarded as reducing considerably the chances of it being driven down too much should things not work out. The idea is to seek significant upside potential coupled with downside protection whilst accepting that this downside protection can never be anywhere near perfect.

If a value share goes very wrong, it can only be because the fundamentals upon which you based your downside protection reliance have failed. For example an unexpectedly severe downturn in business such that net cash has been spent and turned into debt and losses incurred. This actually reduces in one swoop what I consider to be the two most desirable of my four pyad value legs, both net cash and net assets. To sweeten the mix, the third leg of low P/E will have disappeared entirely with quite likely the fourth, a decent yield.

But hang on, you bought because eps forecasts were rising. Well, analysts' forecasts can sometimes go wrong, not just slightly but catastrophically. This is much more likely with small caps in my experience because fewer forecasts are being made, sometimes only one from a tame house broker. Thus in such a situation, not only has the forecast rising eps upon which you relied as an outer been busted, but the safety value features upon which you relied to limit the downside should the outer fail to materialise may largely have been dissipated as well.

Allied to this are the rare circumstances where such events have not arisen merely from an unexpected collapse in the trade, but the directors themselves deliberately and dishonestly set out to mislead analysts and the market. This has happened in the past and not only with small caps either.

But can the investor do anything about all these risks?

Not a lot but there is some. You might wish to avoid very small caps because these risks are I believe more prevalent in that area. Having said that though, small caps are where deep value is most frequently to be found so if you stick with them you need to own a larger portfolio to trade off their individually greater risks. Try to test for forecast quality to see whether past forecasts have been met. A history of frequent failure to do so is not exactly encouraging. Pay attention to particular assets, not merely the overall book value. For example a significant property element, especially if you sniff that it may be undervalued, is obviously far preferable to a load of old machinery.

If you decide to move up into medium and big caps in order to reduce risk, very deep value is much rarer so you need to ease up on the filters but that is a trade off against the probably greater reliability of the information. Other value techniques may be help to lower the risks in the big cap field. An example may be the PEG approach combined with the other value criteria which works better with big caps. The aim as always with value is to find those shares that stick out by being cheaper than their peers, but for no good reason other than market sentiment, and having some sort of outer.

Despite taking all precautions though, you will still go wrong at times. I have on many occasions in the past. You have to be able to roll with the punches and keep on coming back. Consequently maintaining a decent sized value portfolio is perhaps the best way of all to avoid any particular failure having too much of an impact. Doesn't need to be huge but I would increase the size for a small cap portfolio. Maybe up to ten small caps say, but a lot less might be acceptable for a large cap value portfolio.