In simple terms, value investing is an investment strategy that involves purchasing undervalued stocks and holding them until their full intrinsic value is reflected by the market price. A value investor achieves this by searching for stocks that are being underestimated by the stock market because of the effects of bad and good news that impact a company’s fundamentals.
The upside of this kind of investment is that you’re buying stocks for less than they are worth and then profiting on the difference. Keep reading to learn more about value investing and how it works.
How Does Value Investing Work?
Value investing follows the basic rule of investing, which is if you know the true value of something, you’ll buy it regardless of where you purchase it. Stocks abide by the same rule in that even if a company’s valuation doesn’t change, the trading price of stocks is bound to change depending on the condition of the market.
It’s important to note that a fluctuation in the price of a stock, changes the overall return on your investment. A wise value investor does their due diligence to identify stocks that they should invest in because unlike other commodities that advertise when they are going on sale, the same does not apply to stocks.
Through the utilization of fundamental analysis to identify undervalued stocks, the investor then holds the stocks in anticipation of greater rewards in the future.
History of Value Investing
Value investing began during the Great Depression and during the aftermath when investors began focusing on buying companies with long term positive outlooks. This is because during this time, many of these companies were going under and as such, it was a high risk for the investors if the companies liquidated.
With time, value investing has evolved. However, the two famous investors who can be credited for the value investing strategy are Benjamin Graham and Warren Buffet.
Benjamin Graham has been credited as the father of value investing. In 1934, he published the book “Security Analysis” and then, “The Intelligent Investor,” later on in 1949. In the books, Benjamin coined the concepts of value investing, intrinsic value, and establishing a margin of safety.
Graham’s greatest contribution to value investing is introducing renowned investor Warren Buffett, whom he taught at Columbia University and later on joined Graham’s firm for a short stint. Warren Buffet is also known as the CEO of Berkshire Hathaway and is arguably the best-known value investor.
He began investing in his early 20s and achieved tremendous success in the 1960s before becoming the CEO of Berkshire in the 1970s.
What Makes a Great Value Stock?
Here are a few characteristics to look out for when picking a good value stock:
- Steady growth rates
- Relatively stable earnings and revenues
- High dividend yields
- Undervalued share price in comparison to the value of assets
How Do Value Investors Make Money?
Value investors make money when they buy undervalued stocks at a low price and receive dividends. They also profit when the stock price increases in value and they sell the security at a higher price than what they bought it for.
Does Value Investing Beat the Market?
Historically, value investing has a good track record of being an efficient strategy in trying to beat the market. However, it’s important to note that value investing is not a way to get quick money.
Also, in order to “beat the market”, using this strategy alone will not do it. It will take persistence, hard work, and the ability to fail, in order to truly figure out how to “beat the market,” with value investing.
It’s a long-term strategy but when done diligently and while following the investing concepts that were proposed by Graham, it yields handsome rewards.
Example of Value Investing
Value stocks often come from larger cap companies or companies with long term potential. For example, Johnson & Johnson is an excellent example of a value stock. With a strong P/E ratio and long standing track record of consistent dividend growth, J&J is one of Buffet’s own value stock picks of Q2, 2021.
Currently standing at a share price of $162.57 (12/6/21), J&J has a price target of $187 according to Wells Fargo.
What Should I Look for in Value Stocks?
Before buying a stock, it’s important to do your due diligence. Some of the things to look out for are undervalued stocks as well as those with a high potential for growth.
Here are a few other things you should keep an eye out for as a value investor:
Company’s Quality Rating
A company’s quality rating is a thorough analysis of all factors of a company’s financial strength, growth prospects, profit and income generation (stock liquidity), and overall stability. The rating overall is a measure of a firm’s creditworthiness.
A company’s quality rating is important to value investors because it helps them gain a better understanding of the management and utilization of a firm’s capital.
The current ratio is used to measure whether a company can meet its short-term liabilities and is an indicator of liquidity. In short, it is used to measure the financial health of the company.
This information is essential to investors because it helps them determine the current and future outlook of a company.
This is a measure of the value of a company’s stock against the company’s earnings per share (EPS). It’s important in value investing because it is used to determine how much the market is willing to pay for a stock based on its past and future earnings.
The price-to-earnings ratio will be an indicator for how over or under valued a company may be.
D/E is a stock metric that helps investors identify how a company finances its assets. In short, it indicates the ratio of equity to debt a company is using to finance its day-to-day operations.
The D/E ratio is also a measure of risk and of a company’s leverage.
This metric measures whether a stock is properly valued by comparing its assets and liabilities to its market capitalization. It is important to remember that a “good” P/B ratio will vary by industry and there is no one right answer.
It is generally accepted thought that a P/B below 1.0 indicates an undervalued stock however some investors believe anything below a 3.0 can be included as well.
This is an advanced version of the price-to-equity ratio which also considers earnings growth. It provides a clear picture of whether a stock is over or undervalued by considering the present earnings and the expected growth rate.
This is especially important to value investors as once they know the true value of a stock, investment decisions become more clear.
A dividend is a distribution of a company’s earnings to respective shareholders based on a set of guidelines. They can be in the form of cash or additional stock.
The history of distributions of dividends are important to value investors as it is an indicator how much retained earnings a firm has. If you see an increase in the dividends being paid out, that tells us that there was an increase in retained earnings and vice versa.
A decrease in dividend distributions can also signal to investors that a firm may be in financial trouble.
Advantages of Value Investing
- Can be implemented by all levels of investors
- Profits made have a large potential
- Low risk, high rewards
- One can take advantage of compounding interest by reinvesting dividends or profits earned from a specific stock
Disadvantages of Value Investing
- Value stocks can be difficult to find and will not be blatant
- This investment strategy is not for those looking to get rich quick
- You will have to act against the flow which may be hard for some investors
How to Start Value Investing
If you’re new to value investing or maybe you’ve not had success previously with this type of investment, the best approach is doing due diligence to identify value stocks to invest in. This can be achieved through fundamental analysis as well as a general analysis of firms. Here are a few guidelines for new value investors:
Avoid Value Traps– These are types of stocks that appear cheap but aren’t. Some of these stocks include those from cyclical industries like manufacturing and intellectual property stocks. As a value investor, when valuing a stock it’s important to note that the future of a company will not directly reflect its past.
Diversify- The saying don’t put all your eggs in one basket also applies to value investing too. Some of the most successful investors in the world have taken this approach and ran with it. Diversifying your portfolio cushions you from massive losses.
Look for Safe and Steady Returns- Most new investors are impatient. If you want to try your hand in value investing, patience is one of the most important virtues. A suitable approach would be to aim for low-risk and a firm with consistent returns year after year.
Value Vs. Growth Investing
Value and growth investing are related in some ways. If value investing does not work for you, you can consider growth investing.
One distinguishing factor is that growth investing focuses on investing in company’s growing at a higher rate than the market is. The focus is on the fastest-growing companies in the market, whereas value investing focuses on those that are undervalued.
Is Value Investing the Strategy for You?
Value investing is a viable investment option that earns high yields when you purchase the right stocks. By following Graham’s guide on value investing, you’ll minimize risks and increase your profit margins.
However, it’s important to note that value investing is a long-term rather than a short-term investment that requires a lot of patience to realize gains. If you still don’t know where to begin, you should consider enlisting the services of a financial advisor to guide you on how to make value investing work for you.