There is such a thing as a free lunch

I don't know why I bother really, but the answer is probably that I see it as something of an evangelical challenge to proselytise the infidels. Before anyone questions the merit of this in the sense of it possibly attracting too many players, there's little danger of it becoming a very widely followed investment strategy. It will always be a minority approach because its definition is to look for shares that are unreasonably cheap on fundamentals. And the usual reason they are unreasonably cheap is that the majority don't like them or ignore them.


Minority rules
Who is the majority anyway? Overwhelmingly, it is the institutions and professionals that hold and trade by far the bulk of issued shares. Consequently, those are the opponents against whom a value player is betting. They are the ones that, by their trading, cause share prices to move -- especially the larger caps where the small guy is about as influential as a fart in a tornado.

So know your enemy. It is organisations like the Pond Life insurance company, Mathhead & Co algorithm traders, and so on. But one person it is not is someone else on an internet message board.

What I mean is that there may well be heated discussions between readers on boards such as the Fool provides and elsewhere over the merits of a potential value play, or even whether there is any merit in the whole value strategy. But financially speaking, you are not against them, nor are they against you. You may be against each other in a debating society sense, but not where it really counts -- in your wallet.

So when you stick your money down on a value play, it doesn't matter what someone on a message board thinks of that share in particular or the concept in general. They aren't going to determine whether it wins or not. It is the market that will decide that, and the market is comprised principally of those I mention above.

Hardback evidence
There is a lot of evidence around that value works, including books from knowledgeable authors such as David Dreman and James O'Shaugnessy. As far as I know, there isn't much, if any, published evidence to the contrary. This fact is actually an interesting comment on investment publications generally of all types. It would be rare to see a publication produced explicitly to debunk a particular strategy. They seem mainly to be written for the express purpose of expounding the virtues of an approach. Humans like happy endings.

But I'm not here today to remouth stuff from well-known authors. I'd like to put my own reasoning in.

Value trading is an investor's free lunch
I'm going to deconstruct the "no free lunch" popular saying, which has been hopelessly misused by those misunderstanding it and has been cited to condemn value verbally, without any evidence. The source of this prandial argument is the First Law of Thermodynamics, which tells us that the total amount of energy in the universe is constant, it cannot be created or destroyed. Thus you can't win, you can't get something for nothing. But that applies only to the system as a whole. Within that system, individuals demonstrably win and lose. The winners have had a free lunch, maybe at the expense of the losers, but they've still eaten.

Value trading is the investor's free lunch. Why should this be, though? The argument against it says that if it were that easy, most would do it and the advantage would be traded away. But the answer is that it is not that easy, and few have the temperament for it. It takes guts and extreme patience.

Guts because you have to be a contrarian, which isn't easy when everyone around you who doesn't believe in value says the opposite. Patience because the time scale may be much longer than you hope; it could be years on top of what you originally thought. And it takes the understanding because, like a skilled poker play who understands the odds, it is a game of sufficient trades working out to win well overall and therefore knowing that some will crap out. So you never look back when you dump at a loss -- or a profit, come to that -- just move on to the next trade.

Those are the personality traits required for the free lunch value to work. The numbers reason is simply that you are buying something that you think is being sold too cheap. Why doesn't everyone else think the same, given that shares are widely followed, especially larger companies? Because of the substantial irrational streak in human nature. You have only to look around you to see the mad things we do on occasion. If we can kill each other in huge numbers for no sensible reason, slavishly follow all sorts of fashions whatever their merits just because others are doing so, believe in the most ludicrous things, and so on, then merely undervaluing a share is no big deal in the context of human failings.

More stories