If you’re the type of person who researches every big purchase, hoping to get the highest quality merchandise or service for the least amount of money possible—whether it’s a TV, a smartphone, or a car—you’re a value shopper.
Value investors bring that same concept to building a stock portfolio. They seek out stocks they believe are worth more than the current prices reflect.
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.
That doesn’t mean value investors are looking for the cheapest stocks out there.
Their goal is to find stocks the market may be underestimating and, after doing their own in-depth analysis, decide whether those stocks have the potential to pay off over the long term.
Who Made Value Investing Popular?
Billionaire 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.
Buffet is often quoted as saying, “The best thing that happens to us is when a great company gets into temporary trouble. … We want to buy them when they’re on the operating table.”
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., is another super-investor who follows Graham and Dodd’s approach.
And billionaire investor Seth Klarman , chief executive and portfolio manager of the Baupost Group, is a longtime proponent.
How Does Value Investing Work?
Value investing is an 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?
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.
Or, as Buffett’s mentor Graham, put it: In the short run, the market is like a voting machine, tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine—assessing the substance of a company.
What Factors Are Worth Considering?
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-Growth Ratio (PEG)
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.
Determining Margin of Safety
Solid research is the value investor’s first line of defense against losing money on a stock purchase. But while most investors may have access to the same basic information, their valuations could differ greatly.
Just in case that valuation is wrong (because intrinsic value is subjective), investors also can minimize their loss by building in a safety cushion. The idea of using a margin of safety, or leaving some room for error, is a core principle of value investing.
Or, as this Warren Buffet quote puts it: “You build a bridge that 30,000-pound trucks can go across, and then you drive 10,000-pound trucks across it.”
The greater the margin of safety—the difference between the stock’s prevailing market price and its estimated intrinsic value—the higher the potential for high-return opportunities and the lower the downside risk. What’s a good margin of safety? It’s different for everyone.
It all comes down to how much an investor is willing to lose. For example, an investor who uses a 20% margin of safety as a personal guide might buy a stock with an intrinsic value of $100 a share but a price of $80 per share or less. Another investor may feel more comfortable with a 30% to 40% margin of safety.
That investor might have to wait longer for the stock to drop to their price, or they might not ever get the opportunity to add it to their portfolio, but they’re doing what works for him.
Avoiding 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. (Beware the dangers of a chatty neighbor at the yearly barbecue!)
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.
According to the research firm DALBAR ’s latest Quantitative Analysis of Investor Behavior (QAIB), investors lost 9.42% of their investment over the course of 2018, compared with a 4.38% loss by the S&P 500.
“Judging by the cash flows we saw, investors sensed danger in the markets and decreased their exposure, but not nearly enough to prevent serious losses,” DALBAR’s chief marketing officer, Cory Clark, noted in a press release when the study came out in 2019.
“Unfortunately, the problem was compounded by being out of the market during the recovery months,” Clark said. “As a result, equity investors gained no alpha, and in fact trailed the S&P by 504 basis points.”
And that isn’t all that unusual. Over a 20-year period, from 1999 to the end of 2018, while the S&P 500’s average annual return was 5.62%, DALBAR found the average equity investor’s return was 3.88%.
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.
Value investors don’t follow the herd. They eschew the Efficient Market Hypothesis (EMH ), which states that stock prices already reflect all known information about a security.
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.
What Are Some Strategies Value Investors Use?
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.
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.
But those investors can still pursue a value strategy by putting their money into mutual funds or exchange-traded funds (ETFs) that follow the same principles.
Whether an investor is DIYing it or getting help from a professional, value investing is a long-term strategy. Which means it’s usually part of an overall financial plan.
And if all the pieces of that plan align, an investor may be able to better control when and if they want to sell certain shares to help with a home purchase or some other big expense, or for income in retirement.
Want to Give Value Investing a Try?
If you’d like to try value investing, opening an investment account with SoFi Invest® can be a good way to get started.
There are no account minimums, so you can take your time choosing the investments that feel right. And with SoFi Active Investing, you can be as hands on as you like, creating and managing your own portfolio. But you still can ask SoFi’s credentialed financial advisors for help at any time.
If active investing doesn’t suit you—or if it just isn’t a good fit right now—you can use SoFi Automated Investing and have SoFi help make and manage your portfolio without paying a management fee.
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