Can Value Investing be considered a Gamble?

Interestingly, the above question was posed recently on the Value Buddies forum, and attracted considerable interest and wide-ranging views from a variety of participants. The question above was posed from the standpoint that value investing (or any kind of investing, for that matter) can be considered a gamble as it may take a long time for the market price of a security to rise to its intrinsic value. Thus, there is an element of chance and perhaps even luck and is no different from blackjack or slot machines at the casino.

I found this to be a somewhat interesting topic as the subject matter raised was one which many investors would have asked themselves countless times when their investments are stagnant and not doing well. Value investing, by its very nature, requires an investor to purchase part-ownership of a company and hold its shares for more than a few years, in order for business growth to make the company more valuable. If he chose the right company, there would also be a return on his investment in the form of dividends, which come from the cash flows generated by the Company. But to classify an investment as a gamble is somewhat wrong, as I feel that any event which has a probabilistic outcome amid uncertainty qualifies as a “gamble”. However, it must be stressed that value investors will “gamble” with the factors in their favour, in order to increase the odds of success, and reduce the chances of failure.

The proper definition of a gamble is – “any matter or thing involving risk or hazardous uncertainty” (from dictionary.com). While it is generally acknowledged that investment carries risks and uncertainties, value investing, by its very nature, seeks to adequately address the uncertainties while at the same time, mitigating the risks. Uncertainties can be smoothed out through an understanding of the industry in which a company is operating in, and also by studying its long-term track record using ten-year financial analyses (plot this using MS Excel and you can see the trend of revenues, profits and dividends). Though one can argue that uncertainties in terms of economies and industry cycles can never be completely understood or predicted, one can use history as a somewhat reliable guide and factor in a suitable discount to computed intrinsic value as a margin of safety. In terms of risks, these are mitigated when an investor gains a thorough understanding of the business, including what drives it, its business model, prospects, plans and Management quality. Of course, this entails a lot of reading, research, fact-finding and some even go to the extent of visiting the premises and plants/factories to gain a better appreciation of how the business is run from an operational and tactical standpoint. To further mitigate and control risk, an investor can “go the distance” and use Phil Fisher’s “Scuttlebutt” technique of visiting Management and conducting interviews with them on various aspects of the business. Usually, however, being a minority shareholder means that the Management will not allocate time to entertain you, as they have more pressing matters at hand (like running the business day-to-day!). However, some companies have excellent IR personnel who will respond to queries and provide appropriate updates, news and facts when requested to do so.

So back to the question of whether value investing is considered a gamble. Yes it is if you go by the strict definition given by the dictionary; but then again everything in life can then be termed a gamble, from what you choose to study in University, who you marry, which job you take up and which friends you decide to associate with. After all, all these events involve uncertainty and some of them carry a fair amount of risk as well; but we still have to move on and make decisions which seem best under the circumstances. So my assertion is that we all take daily “gambles”, it’s simply the impact which differs for each of these actions that’s all.

From my limited and short experience (less than 4 years) as a value investor, I did note that valuations will normally revert back to the long-term mean, and that if an investor purchased shares in a company whose valuation is trading at a discount to the mean, and the Company is doing well in terms of business growth and cash flows, then one can reasonably expect a reversion to intrinsic value as time goes by. But after going through one complete bull/bear cycle, I have to categorically state that it is by no means easy to spot whether valuations are “cheap” or “expensive” as these terms can be relative, depending on the state of earnings and economic growth in general. One must learn to be flexible and adaptive in assessing valuations and to keep an open mind.

Ultimately, as investors we have to make an intelligent gamble, with the odds tilting in our favour. That’s basically what investing is about, and when the odds are strongly in our favour, then learn to bet larger amounts. If there are too many uncertainties and risks, then an investor should be prudent and only commit a small amount of capital. In other words, we should do position sizing based on our comfort level with a certain company, and this is something which I believe all investors practise. After all, when it comes to the crunch, I dare say a value investor will still do much better than a gambler at a casino playing cards because in the former case, we are talking about business growth and the management of uncertainty; whereas in the latter case, there is the “house advantage” which is an artificially created additional layer of mathematical uncertainty out to sabotage the gambler!