Leveraging the value effect

Many studies have proved that value investing (buying companies at bargain basement prices) produces the best long-term returns (indeed, The Fleet Street Letter’s Charlie Morris wrote all about it in MoneyWeek last week). The efficient market hypothesis suggests that this shouldn’t be the case – as soon as everyone realises that value stocks beat the market, they should pile in and “arbitrage” the benefits away.

Yet no one wants to buy companies that everyone else hates. They’d rather buy popular, fast-growing companies, even if they are more expensive. As a result, the value effect persists – and The Defensive Value Investor by John Kingham, shows how a private investor can take advantage of it to build a low-risk portfolio, providing a reliable income.

Value investing is very focused on specific ratios, such as price/earnings and price/book, and these are the sorts of financial metrics that take up the first third of the book. Kingham wants investors to focus on reliable but unglamorous firms rather than riskier “special situations” (companies in trouble that may or may not be turned around), and so emphasises finding firms with secure balance sheets and stable businesses. This involves some homework, but Kingham gives a straightforward, step-by-step guide to the necessary calculations.

Of course, plenty of aspects of good businesses simply can’t be captured in financial statements alone. The middle three chapters focus on key questions to ask about a company and its operations. Kingham stresses the importance of avoiding “value traps” – stocks that look cheap, but only because they have serious problems. He also stresses the importance of a competitive advantage, to ensure a steady stream of profits.

The final section outlines Kingham’s rules for combining individual picks into a portfolio. These include diversification – how much you need, and how to do it – and advice on when to sell. Kingham backs it all up with his own experiences as a newsletter writer and private investor, devoting a whole chapter to what he has learned from his mistakes.

Purists might argue that Kingham’s insistence on sales growth and rising dividends makes him more of an income than a pure value investor, and those who want to take more risk may feel constrained by his “rules of thumb”. However, overall this is an accessible, well-written and engaging guide, and it is also refreshing to hear a perspective from someone who isn’t a typical City professional. Definitely worth a look for any stock-picking private investor.