Understanding Value Investing
What is Value Investing?
Exploring the Essentials of a Value Investment Approach
Value investing is a strategy where investors purchase stocks that are considered undervalued. The objective is to hold these assets until the broader market recognizes their true worth, resulting in an increase in the stock's price and generating profits for the investor.
Stocks can be perceived as undervalued due to various reasons. The company might be dealing with a short-term issue that is negatively impacting sales and earnings. The industry or specific stock might be out of favor among investors. Or, the overall economy might be experiencing a downturn.
The challenge for the value investor is to differentiate between stocks that are cheap due to genuine reasons versus those that are undervalued gems. This often involves scrutinizing the company's business model and estimating its intrinsic value. Popular valuation techniques include discounted cash flow analysis and comparing key ratios such as the price-to-earnings (P/E ratio), price-to-sales (P/S ratio), and price-to-book value (P/B ratio) with industry peers.
Characteristics of Value Stocks
What Makes a Great Value Stock?
While the primary characteristic of a value stock is a low price in relation to the company's intrinsic value per share, the best value stocks often possess additional appealing qualities. These may include:
- A strong, reliable business model.
- A history of profitability in both good and bad economic conditions.
- Steady revenue and cash flow growth.
- Experienced leadership.
- Low debt levels.
- A solid competitive advantage, such as strong brand loyalty.
- A commitment to returning value to shareholders through share buybacks and/or dividend payments.
Investing in Value Stocks
Why Invest in Value Stocks?
Value investing is typically compared to growth investing, which involves buying stocks of companies that are projected to grow significantly faster than the market or their competitors. Although the two strategies are not mutually exclusive, value investing tends to provide more stable returns with less volatility than growth investing. Growth stocks can soar quickly but plummet just as swiftly.
Value stocks appeal to investors who:
- Prefer less frequent trades.
- Are comfortable with less volatility.
- Are willing to buy when other investors are selling.
- Enjoy conducting in-depth research and analysis.
- Appreciate regular dividend income.
For investors seeking a defensive approach, a good value stock can offer some protection against losses while providing the potential for reasonable gains.
Finding Value Stocks
How to Find Value Stocks
Value investors often initiate their search using a stock screener, which provides a list of public companies that meet certain criteria. These criteria may include:
- Minimum P/E ratio. P/E ratios can vary widely by industry, but many value investors prefer to see this ratio below 15 or 20.
- Minimum P/B ratio. A low P/B ratio (below 1) could suggest the company is undervalued, but it should not be viewed in isolation. A low P/B ratio could also indicate a problem with the business.
- Minimum ROE. ROE (return on equity) indicates how well the company generates returns from its net assets. Higher is generally better.
- Minimum dividend yield. Dividends can provide security in returns. The minimum dividend yield an investor requires is a personal decision. Value investors often target a range higher than the market average but not so high as to be unsustainable.
- 5-year EPS growth outlook. Value stocks with expectant EPS growth are more likely to attract investor attention and support.
- PEG ratio. The PEG ratio (stock's P/E ratio divided by its expected EPS growth rate) should ideally be near or below 1.
Once a list of potential value stocks has been generated, the real work begins. Each stock must be thoroughly examined to estimate intrinsic value and assess whether it meets the desired margin of safety threshold. This process may require reviewing numerous stocks before finding one that meets your criteria.
Value Traps
Avoiding Value Traps
A value trap is a stock that appears cheaper than it should be due to underlying issues. Watch out for these scenarios:
- Overreliance on a single product or market.
- Deteriorating financials.
- Lack of strong management.
- A bloated cost structure.
- Earnings that are premised on unrealistic growth assumptions.
In all cases, careful analysis and research are vital before investing in value stocks to ensure you're not falling into a value trap.
- Companies in sectors like manufacturing and construction, known as cyclical industries, can witness significant earnings growth during economic booms but may experience a sharp decline during market downturns. When investors anticipate an economic slump for a particular stock, its price might appear cheap compared to its recent earnings due to expected earnings decline during weaker industry periods.
- Firms that base their profitability on intellectual property, such as pharmaceutical companies with popular, patent-protected medications or tech companies leading a new market, can fall into the value trap. When patent protections expire, a decline in revenue and earnings for these companies is inevitable unless they have promising substitutes in the pipeline.
Value traps are characterized by lackluster growth prospects in the short and medium term. To avoid them, consider evaluating EPS outlooks and PEG ratios. These metrics, differing from traditional valuation ratios like P/E, provide insight into a company's future prospects.
Should you invest?
Is value investing suitable for you?
If your primary objective is to lower your risk of significant losses while raising your chances of positive returns, value investing might be your cup of tea.
Value investing necessitates tenacity. The process of value identification eliminates numerous stocks and might be frustrating, particularly in bull markets. Although the stocks that you eliminate during your search might appreciate during bull markets, their initial prices may seem exorbitant to you, the payback comes when the bull market ends. Your margin of safety protects you from extreme losses in value, while the dividend income from value stocks encourages you to stay invested even during market downturns, positioning you for recovery gains.
However, if you find pleasure in investing in the most popular stocks on the market, value investing might not appeal to you. Value stocks might not be trendy or exciting, and their business models might not attract your interest.
Growth vs. value investing
Growth vs. value investing
Value investing might not be the right choice if it seems unsuitable. Growth investing, on the other hand, focuses on a company's potential for increased revenue and net income over time. The concentration is on the fastest-growing companies in the market.
Growth investors are less concerned with intrinsic value and focus more on the stock's growth potential. High growth potential justifies more expensive valuations, which is why growth stocks generally have higher P/E and P/B ratios.
How it started
How was value investing born?
The value investing strategy originated from two Columbia University professors, Benjamin Graham and David Dodd. They aimed to develop a logical investing approach that emphasized research, value, and foresight over market timing and price forecasts.
Graham and Dodd introduced their strategy to Columbia University students in 1928. They continuously refined their methodology and eventually published the influential value investment book, "Security Analysis," in 1934. Graham also released "The Intelligent Investor" in 1949.
Famous value investors
Who are the most renowned value investors?
Graham is known as the father of value investing. The second-most well-known value investor was one of Graham's former Columbia University students, billionaire investor Warren Buffett. Alongside studying under Graham, Buffett also worked for him.
Buffett developed his value investing skills as a young man and used the strategy to generate impressive returns for investors before taking control of Berkshire Hathaway in 1965. As Berkshire's CEO, Buffett has an extensive record of outperforming the compound annual growth rate of the S&P 500.
Buffett's approach has evolved over time. He now emphasizes investing in high-quality businesses at reasonable prices instead of focusing solely on undervalued assets. He emphasizes that it is "better to buy a wonderful business at a fair price than a fair business at a wonderful price."
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Enrichment and prosperity through value investing
Value investing is a patient process that requires time and persistence. Economist John Maynard Keynes once said, "The market can remain irrational longer than you can remain solvent." Although timing gains can occur, it is not the norm, especially when investing in value stocks. Price adjustments often take time due to the investment community's slow response to underperforming stocks.
Value investing can be time-consuming in the short term, but the rewards are worthwhile. Learning and applying value investing principles helps you identify qualities that make a stock investable, providing you with in-depth knowledge of your chosen investments. In essence, you become a better-informed investor, which should ultimately result in increased wealth.
Catherine Brock has no position in any of the stocks mentioned. Our Website has positions in and recommends Berkshire Hathaway. Our Website has a disclosure policy.
In the context of value investing, an investor might be interested in exploring stocks with low price-to-earnings (P/E) ratios. This strategy could potentially lead to finding undervalued gems in the market. Additionally, a value-focused portfolio might appeal to investors who prefer less volatility and enjoy conducting in-depth research and analysis.
