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Value's Free Lunch

By Stephen Bland (TMFPyad)
May 9, 2003

There is a well known economist's proverb about there being no such thing as a free lunch. But, and it is a major but, this is from a large numbers, statistical point of view. The economy as a whole can't get something for nothing. As with all such statistical ideas, it tells us nothing about the individual case. Obvious examples are lottery winners. They will have gained handsomely from blind luck but clearly lottery players as a whole must lose since less money is paid out than is staked on each draw.

Many people disbelieve that short-term value or long-term high yield share strategies can outperform the market in the long run. I have discussed this matter many times with people on our discussion boards and elsewhere. Those opposed will often put up comments such as:

"Well, if it was so obvious that this works, why isn't everyone doing it and if they were it would become self defeating" or "If you drop fifty pound notes on the ground they would immediately be picked up" and so on.

This kind of criticism might be valid but for one crucial point. It assumes people are completely rational. The overwhelming empirical evidence is that they are not. That is not to say they are wholly irrational either. In fact there is a lot of rationality in the market but at the same time there is sufficient lack of it to create opportunities. The trick is to find a strategy that will exploit these irrationalities on a regular enough basis to make good returns. I believe that value for the short-term trader, and high yield portfolios for the long-term holder do just this although I am really aiming this article at high yield portfolio (HYP) investors.

Even if the occasional bubble were not enough to convince sceptics that too many investors are irrational, you have only to look at the recent price movements of many shares as the market has risen.

Why is the price of a share 20% or 30% more than a few weeks ago for no change in the fundamentals thus putting it on a lower yield and a higher P/E?

Answer, no reason.

The search for reasons is fruitless even though many commentators feel obliged to say something by way of explanation. There is no rational reason at all. The shares are not "worth" that much more, they can't be because nothing beneficial has happened to them. They are still the same shares. What has happened is simply a change in investor sentiment. This fickle behaviour is exactly the kind of irrationality to which I refer.

The reason long-term HYPs work is simply because they use one of the most well known of all value criteria, dividend yield, to identify shares that for some reason are valued cheaply by the market at that point. They deliver a relatively high yield and enable the investor to buy into that forever, subject to the usual risks. Crucially, this rating is often not because the shares deserve it but because of the irrational reason of excessively poor sentiment. Added to this psychological point is the arithmetical advantage that the additional income over the market gives you a worthwhile edge from the outset compared with a tracker fund.

By capturing a share suffering from temporarily high relative yield you convert what is temporary for the market into permanent for your portfolio. I'm not claiming of course that this is without risk (such as dividend cuts) but if you decide to invest in an HYP this presupposes that you wish to be in equities in the first place, with the associated risks that all shares carry. You may do worse than the market, you have to take that chance, but the likelihood is the opposite and investing is about likelihoods not certainties.

One final point. The standard belief that high yield equates in general to high risk is in fact the exact opposite of what actually happens in practice. The actual likelihood from what I have seen for a portfolio is that, in the long run, volatility (ie. risk) is lower than a tracker fund, income is higher and capital performance is better. A similar effect can be seen amongst equity income funds which I believe outperform trackers over the long term and show lower volatility.

Free lunches are now being served at the HYP café.