Consider the Risks of Value Investing - dummies

By David Stevenson

Two words beautifully sum up the worries of many mainstream investors as they approach value investing: value and trap. In layperson’s language, you can discover an undervalued gem, with a wonderful balance sheet, and buy the share.

You know the share is probably unloved but you don’t care; you think it’s cheap. Unfortunately, many value stocks remain good value and cheap longer than investors can stay solvent, leaving you without the gains you were expecting.

You may well think that a stock is wonderful value, but if no one else shares that insight you end up losing money because the company’s shares become a value trap: that is, they stay cheap for a very long period of time.

Many value investors are by nature long-term investors and are willing to sit tight for many years. But many of the smartest investors also ruthlessly adopt what’s called a stop loss procedure, in which they sell a cheap share if it keeps getting cheaper.

James Montier is a value investor through and through. He believes that private investors can absolutely apply value investing to their investing strategies. For Montier, the only relevant aspect of investment is maximum returns, and so ‘the question becomes, how should we invest to deliver this objective?’. Therefore, he developed his own ten-point plan for future investing success, pithily called his Tao of Investing:

  • Tenet I – Value, value, value: Value investing is the only real safety-first approach. By putting the margin of safety at the heart of the process, the value approach minimises the risk of overpaying for the hope of growth.

  • Tenet II – Be contrarian: As [investor andmutual fundpioneer] Sir John Templeton observed, ‘it’s impossible to produce superior performance unless you do something different from the majority’.

  • Tenet III – Be patient: Patience is integral to a value approach on many levels, from waiting for the fat pitch, to dealing with the value manager’s curse of being too early.

  • Tenet IV – Be unconstrained: Although pigeon-holing and labelling are fashionable, they don’t aid investment. Investors should be free to exploit value opportunities wherever they may occur.

  • Tenet V – Don’t forecast: Investors have to find a better way of investing than relying upon their seriously flawed ability to soothsay.

  • Tenet VI – Cycles matter: As [American investor] Howard Marks puts it, ‘we can’t predict but we can prepare’. An awareness of the economic, credit and sentiment cycles can help with investment.

  • Tenet VII – History matters: The four most dangerous words in investing are ‘this time is different’. Knowledge of history and context can help avoid repeating the blunders of the past.

  • Tenet VIII – Be sceptical: Questioning what you’re told and developing critical thinking skills are vital to long-term success and survival.

  • Tenet IX – Be top-down and bottom-up: Both a top-down viewpoint (wherein investors look at the big economic and financial world picture and then select stocks based on that information) and a bottom-up viewpoint (in which investors focus on the company specifics rather than industry specifics) matter; neither has a monopoly on insight.

  • Tenet X – Treat your clients as you’d treat yourself: Surely the ultimate test of any investment is, would you be willing to invest with your own money?