Revisiting ideas behind true value

The supply of truly good ideas in investing is limited. The number of original ideas is even smaller.

This helps to explain why so many investment books are much the same. Those books still keep coming in a continuing flood and this reflects hyperactive, and somewhat annoying, marketing by publishers, rather than any great gush of new ideas on investing.

However, this is not wholly unhealthy.

There may be only a few truly good ideas in investing but they are difficult to explain. They also need to be reinterpreted for new eras.

And value investing has perhaps a stronger and more coherent set of ideas than any other. Many of its practitioners behave almost as protectors of a holy flame. Here, then, is a set of ideas that dates back at least to the 1930s, to which a committed core of value investors strongly adhere.

To beat the market, you must find stocks that are too cheap. To do this, you must look at the stock not as a security but as a share in a company, which is, in turn, a bundle of incomeproducing assets.

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Market vultures will await more blood on the streets

One of the most successful investors to bet on a credit crunch was Jim Melcher, who has run Balestra Capital, a small New York hedge fund, for almost a decade. It has doubled so far this year. He did this by exploiting the complex new debt instruments that are now exploding in the faces of their inventors.

For example, he bought credit default swaps (CDSs) against a range of 30 collateralised debt obligations (CDOs) that were rated AA. Translated into English, he bought insurance against default by packages of loans that were not the highest quality, but were not junk either.

The cost to him, the effective premium, was 0.6 per cent per year. This was the most he could possibly lose from the strategy. The potential profit, if all the bonds issued by the CDOs were to default, was 100 per cent. He now expects to make this on about 20 of the CDOs for which he bought protection. "I've never seen a cheaper play to make where you could take less risk with more return than I was offered in this market," he says. That was a classic value investor's investment - tiny risks to the downside, with potentially huge profits. He is not waiting for the CDOs to go to zero and has taken profits on a third of these bets. In one case this involved taking $7m for an investment that had cost about $50,000 some months earlier.

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