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VALUE INVESTING
Expected Returns From A Value Strategy

By Stephen Bland (TMFPyad)
November 14, 2003

Expected returns was the subject of a recent thread on the value board started by our reader caselaw. It is an interesting story. He shows how well he has done in recent years with his personal pension fund. He transferred the investments from management by the dead hand of an insurance company into a self-invested scheme, in which he has traded equities by using a value approach. This success does not surprise me, because I know that value works. Nevertheless, it is always good to hear real life individual evidence of this.

Incidentally poor performance from insurance company investment management does not surprise me either. Use them by all means for insurance but for investment? Would you ask a plumber to fix your teeth?

Caselaw goes on to express doubt as to whether his success is luck or skill, and consequently whether he can maintain his success in the future. The answer is that it is skill but not necessarily share selection skill. That part of it is relatively easy, being largely a matter of simple arithmetic. The much harder part is the requirement to be contrarian in nature, going in where non-value investors would not, together with the patience to follow through. This is likely to require, on occasion, sitting out falling prices. You need to stick to the principles over extended periods and not give up due to the inevitable setbacks that will occur.

It is difficult, and in my view unnecessary, to put a figure on the expected returns from a value strategy. All the evidence I have seen though, both from my own experiences and other individuals plus published works from authors such as David Dreman and James O'Shaugnessy points to the likelihood that value will do much better than the background market and far better than cash. Exactly how much better will vary dramatically with the individual value investor. My belief is that value will be rewarded by a worthwhile premium to the market and cash over time.

The reason that I do not think that existing value investors, or more likely newcomers, should try to seek any particular target return is because setting a target takes your mind off the target. That target is to locate and trade value shares for a profit, but what profit exactly cannot be predetermined and you should not try to do so. Don't expect for example 15% per annum then you won't be disappointed if you achieve only 14%. The fact is that a long term annual return of 14% is far better than cash, the market and the great majority of equity investors, private and professional. If you get it right the returns should be attractive but I advise against worrying about specific figures. I would say though that if over long periods you average a figure that is worse than cash or worse or little better than the market, then you are doing something wrong.

Setting target returns is bad because it may influence your sell decisions, leading you to use, perhaps subconsciously, a technical stop-profit approach which is pointless for value, just as a stop-loss style is for this strategy. By this I mean that you should not sell a value share just because it has risen by some preset amount of X%, that should not be your sell signal. Value fundamentals should be your sell signals, with a little psychology on occasion such as a contrarian approach to press comment.

There will always be someone better than you out there, or who claims to be, but forget about it if possible. If you have over a long period averaged say 15-20% per annum and you then read on our board or elsewhere of someone achieving a far greater return it does not mean that you are a failure as a value investor. It means you have been a great success, even if it may not feel that way in comparison to others. A return of this scale in fact puts you into a tiny fraction of very successful investors, given that the UK stock market general return is around half that.

Think of all the huge numbers out there who have actually lost money or made very little from shares over the years. When you include all those people who invested in poorly performing insurance and other funds as well as individual shares I am convinced that this is probably the majority of investors. These are the poor guys with whom you should compare yourself, not the tiny handful of outstanding successes.

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