Value investing is the act of selecting stocks that appear to be trading for less than their intrinsic or book value. Investors who look for stocks undervalued by the market actively seek them out. A company’s stock price movement may not reflect its long-term fundamentals when the market reacts overly strongly to both good and bad news. By taking advantage of the overreaction, you can purchase stocks at discounted prices on sale.
A value investing strategy is typically compared to a growth investing strategy, which focuses on finding stocks with the greatest growth potential. Therefore, value stocks generally have lower relative multiples and pay dividends, whereas growth stocks don’t and have higher multiples.
Value Investing: How it Works
Value investing, in its simplest form, involves finding bargain prices on stocks. The value investor identifies stocks’ intrinsic value by using fundamental analysis methods. The Price-to-earnings ratio, debt-to-equity ratio, price-to-book ratio, and price/earnings-growth ratio can all be used in this analysis.
A value investor may determine if the price of a stock reflects the stock’s intrinsic value once they are confident with their estimate of the stock’s intrinsic value. The value investor may further assess whether or not to purchase shares when the price appears to be below the intrinsic value of the stock. A stock whose price appears to be higher than its intrinsic value may be monitored by the investor and waited for a more appropriate price to be set.
Fundamentals of Value Investing
While implementing their investment strategy, value investors usually adhere to several investing principles. Some key principles of value investing may involve the appraisal of intrinsic value, seeking a margin of safety, taking a long-term view, or taking a contrarian approach.
1. Evaluation of the intrinsic value
In value investing, an investor identifies what they believe is the true underlying value of a company. This is its intrinsic value. They then look for shares at a discount to that value. A valuation metric such as the P/E ratio may be used by the investor to determine this value.
2. Aiming for a safety margin
It is said that the margin of safety of a stock is determined by its intrinsic value and its current price. According to theory, the higher the margin of safety (intrinsic value less market price), the greater the price growth potential.
3. Prospects for the future
The intrinsic value of stock purchases is often surpassed or reached after many years by value investors, who are generally patient in waiting for the price to rise.
4. Alternative viewpoints
Investors who seek value may invest in ways contradictory to the herd. It may be tempting for them to acquire shares of a quality company at a bargain price when the stock of a quality company is mispriced due to investors selling.
Stocks that are undervalued increase in value
There are several factors that can cause a change in stock prices, but supply and demand always play a predominant role in how stock prices move. It is, therefore, possible for an undervalued stock to increase in value because the larger market has realized its value and the demand for the stock has risen. In addition, the price of many stocks may simply have increased because of macroeconomic or political factors.
Moreover, value investing has been a popular strategy among institutional investors like pension funds and endowments. Institutions sometimes move in or out of certain stocks in a herdlike manner. Institutions can cause value stocks to become in or out of favor, which can lead to broad price increases or decreases.
A Value Investing Strategy Requires Diligence and Patience
The process of determining a stock’s true intrinsic value involves some financial analysis, but also a fair amount of subjectivity. Therefore, it is more of an art than a science sometimes. Investors can arrive at different valuation decisions when analyzing the same company’s valuation data.
In some cases, investors who look at only existing financials do not place great faith in estimating future growth. Those who invest in value mainly look at a company’s projected growth and cash flow. Many value investment gurus look at both financial statements and valuation multiples to identify mispriced securities, such as Warren Buffett and Peter Lynch, who managed Fidelity Investment’s Magellan Fund for several years.
There are many different approaches to value investing, but they all have the same underlying logic: you purchase assets for less than they are currently worth, hold them for a long period of time, and profit when they return to their intrinsic value or beyond. Instant gratification is not provided. The price of stock can’t go from $50 on Tuesday to $100 on Thursday just by buying it on Tuesday. In contrast, your stock investments may not pay off for years, and you will occasionally lose money. Long-term capital gains are taxed at a lower rate for the majority of investors than short-term investments.
Strategies for Value Investing
Researching a company thoroughly and making a commonsense decision are the keys to buying an undervalued stock. According to value investor Christopher H. Browne, companies can increase revenue by using the following methods:
- Increasing the price of products
- To increase sales
- By reducing expenses
- Unprofitable divisions are sold or closed
As part of evaluating a company’s future growth prospects, Browne suggests studying its competitors. In all of these cases, however, the answers are speculative, lacking any kind of solid quantitative support. The lack of quantitative software programs makes value stock investing somewhat of a guessing game because these answers cannot yet be obtained. Warren Buffett recommends investing only in industries you’ve worked in or whose consumer products you are familiar with, such as cars, clothes, appliances, and food.
Investing in stocks of companies that sell products and services in high demand is one way to gain a competitive edge. Despite the difficulty of predicting when innovative new products will capture market share, it is easy to gauge how long a company has been in business and see how it has adapted to challenges over time.
Example of Value Investing
Market overreactions caused by quarterly earnings reports can provide a great opportunity for value investors. Fitbit released its Q1 2016 earnings report on May 4, 2016, and after-hours trading decreased sharply. The company’s value plummeted nearly 19% after the flurry. While it is not uncommon for a company’s share price to drop significantly after releasing earnings, Fitbit exceeded analysts’ expectations for the quarter and even raised its 2016 guidance.
According to the company, its first quarter of 2016 revenue was $505.4 million, up over 50% compared with the same period last year. Fitbit estimates that it will generate between $565 million and $585 million in the second quarter of 2016, compared to analysts’ forecasts for $531 million.
It appears that the company is doing well and growing. Due to Fitbit’s significant investment in research and development, its earnings per share (EPS) decreased compared to a year ago. Investing in Fitbit was all it took for the average investor to sell off enough shares to depress the price. The value investor, on the other hand, focuses on the fundamentals of Fitbit and recognizes that it is an undervalued stock, with the potential to grow in the future.
Benefits and Drawbacks of Value Investing
Benefits of Value Investing
- Dividend earnings: Value stocks typically pay dividends to investors. The dividends may be used to buy more stock or taken as income by the investors.
- Relative stability: Value stocks are less volatile than growth stocks, so they produce more consistent returns.
- Growth potential: Value stocks are likely to appreciate in value over time in addition to dividends.
Drawbacks of Value Investing
- Loss potential: Value stocks, like other types of stocks, are vulnerable to principal risk, which means their value could decline below what they invested.
- Taking time: Methods such as value investing, fundamental analysis, and active management require time.
- Objective: The determination of intrinsic value and price is subjective in nature, as it requires estimates of future earnings, cash flow, and interest rates, in addition to determining how investors will value stocks in the future.
Famous Value Investors
Bill Ackman, Charlie Munger, and Warren Buffett are some of the most famous value investors in investing history. Investors who aspire to emulate their style and success typically mention these investors as some of the top names.
Benjamin Graham: Widely recognized as the father of value investing, Graham was a British-American economist and investor who wrote or co-wrote two classic value investing books, Security Analysis, and The Intelligent Investor.
Warren Buffett: Buffett became one of the richest people in the world after following the value investing style of Benjamin Graham, chairman, and CEO of Berkshire Hathaway Inc (BRK.A).
Charlie Munger: A billionaire investor and former real estate lawyer, Munger is Berkshire Hathaway’s Vice Chairman and is considered to be Warren Buffett’s best friend.
Bill Ackman: Ackman is the founder and CEO of Pershing Square Capital Management, a hedge fund that invests in distressed (undervalued) companies.