Understanding Value Investing: Principles, Strategies, and Risks
Value investing is an investment philosophy that takes an analytical approach to selecting stocks based on a company’s fundamentals — such as earnings growth, dividends, cash flow, book value, and intrinsic value. Value investors don’t follow the herd when it comes to buying and selling, which means they tend to ignore tips and rumors they hear from coworkers and talking heads on TV.
Instead, they look for stocks that seem to be trading for less than they should be, perhaps because of a negative quarterly report, management scandal, product recall, or simply because they didn’t meet some investors’ high expectations.
What Is Value Investing?
A value investor’s goal is to find stocks that the market may be undervaluing. And after conducting their own analysis, an investor then decides whether they think the targeted stocks have potential to accrue value over time, and to invest.
In effect, value investing is an investment strategy that involves looking for “deals” in the market, and taking portfolio positions accordingly.
Historical Background and Evolution
Value investing has been championed and used by some of the most storied investors in history. For example, Warren Buffett, the CEO of Berkshire Hathaway, also known as the “Oracle of Omaha,” is probably the most famous (and most quoted) value investor of all time.
From 1965 to 2017, Buffett’s shares in Berkshire Hathaway had annual returns of 20.9% compared to the S&P 500’s 9.9% return.
Buffett’s mentor was Benjamin Graham, his teacher at Columbia Business School and later his employer, who is known as “the father of value investing.” Columbia professor David Dodd, another Graham protegee and colleague, is recognized for helping him further develop several popular value investing theories.
Billionaire Charlie Munger, vice chairman of Berkshire Hathaway Corp., was another super-investor who followed Graham and Dodd’s approach. And billionaire investor Seth Klarman , chief executive and portfolio manager of the Baupost Group, is a longtime proponent.
Joel Greenblatt, who ran Gotham Capital for over two decades and is now a professor at Columbia Business School, is the co-founder of the Value Investors Club.
The Core Principles of Value Investing
The main goal of value investing is to buy a security at a price that is near or less than its intrinsic value. That is, the investor is not paying a premium or markup on the stock — they’re getting a “deal” when they invest in it. There can be many elements at play when determining a value stock, including intrinsic value, margin of safety, and market inefficiencies.
Intrinsic Value and Margin of Safety
Intrinsic value refers to a stock’s “true” value, which may differ from its “market” value. It can be a difficult concept to wrap your head around, but at its core, determining a stock’s intrinsic value can help an investor determine whether they’re actually finding a value stock, or if they’d potentially be overpaying for a stock. That’s why the concept of intrinsic value is critical to value investors.
Similarly, investors need to incorporate a “margin of safety,” which accounts for some wiggle room when they’re trying to determine a stock’s intrinsic value. In other words: Investors can be wrong or off in their calculations, and calculating a margin of safety can give them some margin of error when making determinations.
Belief in Market Inefficiencies
Value investors also tend to believe that the market is rife with inefficiencies. That means that the market isn’t perfect, and doesn’t automatically price all stocks at their intrinsic values — opening up room to make value investments. If you, conversely, believe that the market is perfectly efficient, then there wouldn’t be any stocks that are priced below their intrinsic value.
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Strategies and Techniques in Value Investing
Value investing isn’t about finding a big discount on a stock and hoping for the best, or making a quick buck on a market trend.
Value investors seek companies that have strong underlying business models, and they aren’t distracted by daily price fluctuations. Their decisions are based on research, and their questions might include:
• What is the potential for growth?
• Is the company well managed?
• Does the company pay consistent dividends?
• What is the company doing about unprofitable products, projects, or divisions?
• What are the company’s competitors doing differently?
• How much do I know about this company or the business it’s in?
Investors who are familiar with an industry or the products it sells (either because they’ve worked in that business or they use those goods or services) can tap that knowledge and experience when they’re analyzing certain stocks.
The same line of thought can be applied to companies that sell products or services that are in high demand. That brand might be expected to remain in demand into the future because the company has a reputation for evolving as times (and challenges) change.
Identifying Undervalued Stocks
Identifying undervalued stocks requires time, patience, and some good, old-fashioned analysis. That mostly includes fundamental analysis, which is a method of evaluating securities by looking at its underlying financial health. That typically involves digging into financial statements and records.
Analyzing Financial Statements and Reports
Investors who are time-crunched or still learning the basics might find the homework daunting. Deep diving into earnings reports, balance sheets, and income statements, and pondering what the future might hold isn’t for everyone.
Understanding Market Dynamics and Herd Mentality
Doing what feels right on a personal level instead of going with the flow is a big part of value investing. And it isn’t always easy.
If everyone around you is talking about a particular stock, that enthusiasm can be contagious. Which is why a typical investor’s decision making is often heavily influenced by relatives, co-workers, friends, and acquaintances.
For an investor who believes the pursuit of market-beating performance is more about randomness than research, emotions (fear, greed, FOMO) can be their worst enemy. Behavioral biases can lead to knee-jerk reactions, which can result in investing mistakes. It takes patience and discipline to stick with a value investing strategy.
This is all to say that investors should do their best to get a handle on overarching market dynamics, rather than investing emotionally or going with the crowd.
Value investors don’t follow the herd. They eschew the efficient market hypothesis, which states that stock prices already reflect all known information about a security (market inefficiencies!).
Value investors take the opposite approach. If a well-known company’s stock price drops, they look for the reasons why the company might be undervalued. And if there are strong signs the company could recover and even grow in the future, they consider investing.
Value vs Growth Investing
Value investing is often discussed alongside growth investing. Value versus growth stocks represent different investment styles or approaches.
Differences and Performance Comparisons
In a general sense, value stocks are stocks that have fallen out of favor in the market, and that may be undervalued. Growth stocks, on the other hand, are shares of companies that demonstrate a strong potential to increase revenue or earnings thereby ramping up their stock price.
In terms of performance value stocks may not be seeing much price growth, whereas growth stocks may be experiencing rapid price appreciation.
Pros and Cons of Each Approach
Both value and growth investing have their pros and cons.
Value investing, for instance, may see investors experience lowering volatility when investing, and also getting more dividends from their investments. But their portfolio might accrue value more slowly — if at all. Conversely, growth investing may see investors accrue more gains more quickly, but also with higher levels of volatility and risk.
The Process of Value Investing
As noted, value investing is a type of investing strategy, but it’s similar to how a value shopper might operate when hoping to buy a certain brand of a smartwatch for the lowest price possible. If that shopper suddenly saw the watch advertised at half the price, it would make them happy, but it also might make them wonder: Is there a new version of the watch coming out that’s better than this one? Is there something wrong with the watch I want that I don’t know about? Is this just a really good deal, or am I missing something?
Also as discussed, their first step would likely be to go online and do some research. And if the watch was still worth what they thought, and the price was a good discount from a reliable seller, they’d probably go ahead and snap it up.
Investing in stocks can work in much the same way. The price of a share can fluctuate for various reasons, even if the company is still sound. And a value investor, who isn’t looking for explosive, immediate returns but consistency year after year, may see a drop in price as an opportunity.
Value investors are always on the lookout to buy stocks that trade below their intrinsic value (an asset’s worth based on tangible and intangible factors). Of course, that can be tricky. From day to day, stocks are worth only what investors are willing to pay for them. And there doesn’t have to be a good reason for the market to change its mind, for better or worse, about a stock’s value.
But over the long run, earnings, revenues, and other factors — including intangibles such as trademarks and branding, management stability, and research projects — do matter.
Finding and Evaluating Value Stocks
Value investors use several metrics to determine a stock’s intrinsic value. A few of the factors they might look at (and compare to other stocks or the S&P 500) include:
Price-to-earnings Ratio (P/E)
This ratio is calculated by dividing a stock’s price by the earnings per share. For value investors, the lower the P/E, the better; it tells you how much you’re paying for each dollar of earnings.
Price/earnings-to-earnings Ratio (PGE)
The PEG ratio can help determine if a stock is undervalued or overvalued in comparison to another company’s stock. If the PEG ratio is higher, the market has overvalued the stock. If the PEG ratio is lower, the market has undervalued the stock. The PEG ratio is calculated by taking the P/E ratio and dividing it by the earnings growth rate.
Price-to-book Ratio (P/B)
A company’s book value is equal to its assets minus its liabilities. The book value per share can be found by dividing the book value by the number of outstanding shares.
The price-to-book ratio is calculated by dividing the company’s stock price by the book value per share. A ratio of less than one is considered good from a value investor’s perspective.
Debt-to-equity Ratio (D/E)
The debt-to-equity ratio measures a company’s capital structure and can be used to determine the risk that a business will be unable to repay its financial obligations. This ratio can be found by dividing the company’s total liabilities by its equity. Value investors typically look for a ratio of less than one.
Free Cash Flow (FCF)
This is the cash remaining after expenses have been paid (cash flow from operations minus capital expenditures equals free cash flow).
If a company is in good shape, it should have enough money to pay off debts, pay dividends, and invest in future growth. It can be useful to watch the ups and downs of free cash flow over a period of a few years, rather than a single year or quarter.
Over time, each value investor may develop their own formula for a successful stock search. That search might start with something as simple as an observation — a positive customer experience with a certain product or company, or noticing how brisk business is at a certain restaurant chain.
But research is an important next step. Investors also may wish to settle on a personal “margin of safety,” based on their individual risk tolerance. This can protect them from bad decisions, bad market conditions, or bad luck.
Long-Term Considerations and Patience
An important thing to remember when it comes to value investing is that investors are likely on the hook for the long term. Many value stocks are probably not going to see huge value increases over short periods of time. They’re fundamentally unsexy, in many respects. For that reason, investors may do well to remember to be patient.
Risks and Challenges in Value Investing
As with any investment strategy, value investing does have its risks. It tends to be a less-risky strategy than others, but it has its risks nonetheless.
For one, investors can mislead themselves by making faulty or erroneous judgments about certain stocks. That can happen if they misunderstand financial statements, or make inaccurate calculations when engaging in fundamental analysis. In other words, investors can make some mistakes and bad judgments.
Investors can also buy stocks that are overvalued – or, at least overvalued compared to what the investor was hoping to purchase it for. There are also concerns to be aware of as it relates to diversification in your overall portfolio (you don’t want a portfolio overloaded with value stocks, or any other specific type of security).
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The Takeaway
Value investing is a type of investment strategy or philosophy that involves buying stocks or securities that are “undervalued.” In effect, an investor determines that a stock is worth more than the market has valued it, and purchases it hoping that it will accrue value over time. While it’s a strategy that has its risks, it’s been used by many high-profile investors in the past, such as Warren Buffett.
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FAQ
What are the pros and cons of value investing?
Pros of value investing include that it tends to be a less risky investing strategy, and that value stocks may experience less volatility. Some of the cons are that value stocks may not see sizable value increases over short periods of time, and that it’s possible investors can make a mistake and purchase an overvalued stock, rather than an undervalued one.
Is value investing high risk?
Value investing is generally considered to be a lower-risk investment strategy, as investors tend to buy securities that they perceive to be undervalued, rather than overvalued.
Can you make money value investing?
Yes, investors can make money utilizing a value investing strategy. Many of the most successful investors in history, such as Warren Buffett, used a value investing strategy to great success.
How do you do value investing?
Value investing involves purchasing stocks or other securities that an investor has determined to be “undervalued” by the market. Investors purchase those securities, with the hope that they’ll accrue value over time.
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