Tuesday, January 11, 2011

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!

14 comments:

la papillion said...

Hi mw,

I tried replacing 'investing' with 'trading' :) It works! haha :)

Createwealth8888 said...

Value investing, investing, and trading are all speculative in nature and only the degrees and levels of speculation and/or leverages make them different.

Chong Jun said...

I just look at it as no risk no gain, be it gambling or not. lol.

and lp, trading is considered more of a gamble compared to value investing?! haha!

8percentpa said...

I think Ben Graham puts it best. "An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative"

ie if you have done your homework and determine there is money to be made by putting on your capital - it is investing.

So by this definition, black-jack card counters or professional poker players who trained hard, do serious analysis during the game, see opportunity to make money - they are strictly speaking not gambling/speculating

Singapore Man Of Leisure said...

Professional poker players who use analysis are not gamblers? Hmmm....

And I thought all forms of investing has a gamble element in it.

So there is ying in yang, and yang in ying!

Musicwhiz said...

Hi LP,

Haha cannot leh, if I changed it to trading I will have to rewrite the article! :P

Cheers,
Musicwhiz

Musicwhiz said...

Hi CW8888,

I don't exactly agree with that, but you are entitled to your own views. Let's respect that and agree to disagree.

Thanks,
Musicwhiz

Musicwhiz said...

Hi Chong Jun,

Yes, no risk no gain, and sometimes no risk = negative gain; like when you leave your money in the bank and it is eroded through inflation. A simple DCA strategy or buyinf ETFs can settle that problem.

Regards,
Musicwhiz

Musicwhiz said...

Hi 8percentpa,

I agree on the blackjack analogy - there used to be card counters who really polished their skill before making bets, but these have routinely been banned from casinos. Of course investing assumes a certain risk for an uncertain future; but if the odds are in our favour then we would have mitigated the risks.

Thanks,
Musicwhiz

Musicwhiz said...

Hi SMOL,

I think investing per se is to share in the growth of a business. By definition, a business itself is a "gamble" in that you do not know if it is going to prosper or not. So going by this, then yes it is somewhat of a gamble. But if the operations has a good track record and history then the risks of it not doing well are mitigated.

Regards,
Musicwhiz

Market Strategist said...

Trading / investing is no different from other craft. The more practice you have, the better you become.

Musicwhiz said...

Hi Market Strategist,

Yeah, I'd like to think so too with respect to investing! I certainly hope to get better over time.

Cheers,
Musicwhiz

Temperament said...

Hi MZ,
Investments vs.Investors
"The key point is that any investment may be either risky or secure depending on the investor. What is risky to one person may be the safest investment in the world to another. Anytime someone asks me questions such as, "Is real estate risky?" or "Isn't it risky to quit your job to start a business?" my answer is always "It depends." These things certainly can be risky - to some people - but they can also be wise and safe for others.
I have friends who have done very well in real estate, and others who lost big with real estate.
The difference is those who do well have more knowledge, they write better contracts, they know how to manage the properties, and they mitigate their risk by doing thorough due diligence on the people who use their properties.
In addition, those who I've seen thrive with real estate happen to love working with real estate; it's their SOUL PURPOSE.
The others have very little knowledge of real estate(most of the time they get into it only because they think it will make them a lot of money), they write poor contracts that open them to great risk, they manage their properties poorly, and often these properties are damaged by renters the owners never checked out properly. The risk or lack thereof isn't in the real estate; it's in the people who invest in it"
By - B. GUNDERSON.
Cheers! (Hope you enjoy reading)

Musicwhiz said...

Hi Temperament,

Yes I agree with you. It depends on what you are good at, and as you call it "Soul Purpose", haha. For me to dabble in properties would probably be suicide as I do not understand properties well enough.

Thanks,
Musicwhiz