The Pyschology of the Value Investor
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I've touched before on the psychological aspects of value investing. One of the reasons that value or crisis investing works at all is due to the phenomenon of fashion, the herd mentality. It is pretty clear that investment is to some extent motivated by fashion. This applies as much to institutions, which in practice dictate markets, as it does to private investors. I guess most of us are victim to this at some times, whether in investing or other walks of life. It is prevalent in many areas of what we do in our everyday activities, not just obvious stuff like clothing or hairstyles. Whole businesses exist to serve certain fashionable areas of life.
For example, gyms – sorry, "fitness centres". What did people do to keep fit before these came along? There are now a number of quoted companies in the gyms business. Inevitably when some business idea becomes popular, too much competition is set up and a number of players end up failing. I'm not singling out this particular business. But it just so happens that I was reading the results recently of one of these chains that was already in difficulties. Others continue to be successful as far as I know. Often these businesses are retail in nature. But not always, of course. In the last few years this kind of thing has arisen in various kinds of new technology. A while back there was a tremendous growth in biotech shares, followed by a spectacular collapse. And so on. This is not new, only the industries change. I expect crowd psychology is as old as the human race.
The problem for the investor is how to avoid getting caught up in these fads, with the consequent risk of losing money. If you are clever enough, you can get in near the bottom and out near the top of such shares. The growth investor's dream. Great if you can pull off the trick, but how many can? I would ditch value right now if I could figure out how to get in on the ground floor of these rapidly growing companies, and out long before they fall back. But I found out a long time ago, the hard way, that I don't possess such investment skills.
Apart from me, I don't believe many other investors possess the ability to trade successfully and repeatedly like this either. The problem as I see it is that there are too many shares that appear to offer the requisite promise. But experience leads one to believe that only a fraction will make it. Which ones? I don't know, so I'm not going to find out. But I have every admiration for those that can discover the good buys. So many small private investors join the party too late with this kind of share. They notice it only because it is brought to their attention, probably by press comment or other tip. But often by then it is too late.
The massive past growth may well have peaked and decline is setting in. People are attracted by past success and are inclined to believe it will continue. We are fundamentally optimistic by nature. Generally bulls outnumber bears. In some cases past success does continue spectacularly, and if you locate the right shares you can do well at it. Whole strategies here and on the US Fool site are based on the concept of selecting highly-rated past winners that look like repeating their performance. If a fast-growing company is on a P/E of 30 and maintains, or even accelerates, the EPS growth then the shares will probably do very well. Again, it is not my style, because I don't believe I possess the necessary analytical skills to locate such shares and trade them at the right points. And because if you get it even slightly wrong, such highly rated shares crash. There is usually little downside protection.
But value attracts because it is easier to locate. It is a lot simpler to identify shares that have potential, but in which few are interested for fashion reasons, than it is to find exciting growth shares. The reason is simple, there are too many shares on offer with growth prospects. How many small companies are there around with new technology, new retail ideas or whatever? Hundreds. How many are going to score? Only a few. How do you choose the good ones? Dunno.
But how many deep value pyad shares are there? As anyone following this series or the message board will know, most times, none at all. Maybe a handful in a year. To me the logic is staggeringly simple. By forcing myself, through sphincterally tight filters, to locate only a small number of shares, I am not put in the situation of growth or other investors in having to decide in which share out of a large number I am prepared to invest. I avoid the risks of having to pick my shares from a large pool. One less thing to go wrong.
And minimising risk, or downside, is my primary aim in share selection. Before you try and look at how much a share will make, try to avoid losses. I have stated this repeatedly and will continue to do so. It is the bedrock of the value investor. The more safety features the better. So anti-fashion rules with value. There are substantially fewer real value shares than potential growth ones. Use this fact to your advantage. Even if your value criteria are less rigid than mine, it is likely that your filters will throw up only small number of shares.
From a market standpoint, become the guy with flares when everyone else is buying drainpipes. Or the woman in the mini-skirt when other ladies are wearing ankle-length. Or even the man in the miniskirt...
It is not always that easy to act like this. To avoid the powerful temptations to follow fashion, in the belief that because "everybody" is doing something, it must be right.
And be careful though, this does not mean that always doing the opposite of everyone else will win. Only in certain situations and under certain conditions. Occasionally, just occasionally, the majority can be right. This happened to me with British Steel a few years ago. Ostensibly a perfect pyad play, it lost serious money for me before I cut it after a year or so. The fundamentals were perfect. A textbook case. Everything fitted: rising EPS, the lot. The problem was that forecasts for the year after the current one were showing a decline. Supposedly, this was due to the strong pound hitting exports of the company, which were crucial to EPS. Most press and broker comment was negative on the company. But I saw it differently; it had an immensely strong balance sheet with pots of cash, a good yield, low P/E forecast on the current year, and so on. But additionally I was betting that all the pundits had got it wrong for the second year of forecast. I didn't really believe that the strong pound was going to have as dramatic an effect on EPS as everyone was saying. I was taking an absolute contrarian stance and believed that they had got it wrong. I was hoping that that second year, although it might be hit to some extent, would not suffer nearly as much as the dire predictions.
In the event I got it wrong. EPS declined and continued to go nowhere until the recent merger of the company. I got out at a loss, but they continued to decline after my sale, only recovering after a few years with the merger, and even then only to around what I paid. The majority of commentators were right and I was wrong.
It happens. Never look back.
