How Does Value Investing Work?
The goal of a value investor is to identify and acquire assets at a bargain before the market corrects itself. Though this strategy is often applied to stocks, it can also be used for bonds, real estate, and other investments.
The concept of value investing is rooted in the difference between its intrinsic value and its market price.
● Intrinsic value is how much a company's stock should be worth based on its financial performance and health.
● The market price is how much investors are willing to pay for a share of this stock.
Fundamentally, Graham and Dodd argued that the market is often irrational. Investors may over or even under-react to the latest news about the company. Macroeconomic trends such as high inflation or changes in federal interest rates may also sway market prices even though these influences are not directly related to the company itself.
Regardless of the situation, market fluctuations create discrepancies between the current share price and the company’s intrinsic value. When this occurs, it's an opportunity for the investor to acquire the asset for less than what it's worth.
The expectation is that since the company is financially stable, the market will eventually realize the company’s true potential. This will be reflected in a rising share price as it slowly gravitates upward toward its intrinsic value.
Value Investing Principles
Anyone who wishes to adopt a value investment strategy can do so by operating within the following four principles.
1. Know the Company’s Intrinsic Value
The cornerstone of any good value investment is that the underlying asset is high quality. For securities, this means that the company is in good financial standing and well-positioned to be profitable in the foreseeable future.
For this to be known, the investor must do their diligence and estimate the company’s intrinsic value. This assessment can be done both quantitatively and qualitatively.
Quantitative analysis of intrinsic value can be performed using any of the following popular performance metrics:
● P/E (price to earnings) ratio - Compares a company’s stock price against its earnings per share (EPS). A P/E ratio lower than other companies within the same industry can signal a combination of high earnings relative to a low stock price.
● P/B (price to book) ratio - Compares a company’s stock price against its book value. If the P/B ratio is less than 1.0, then it means the stock price is undervalued relative to the company’s net assets.
● Dividend Yield - Compares a company’s dividend payment against its stock price. The higher the dividend yield, the lower the company’s price is relative to its distribution.
● D/E (debt to equity) ratio - Compares a company's total debt against the total shareholder equity. A higher D/E ratio means the company may have taken on too much debt which could result in future challenges covering its liabilities.
● Etc.
An investor can also access the company’s intrinsic value qualitatively by performing fundamental analysis. This is a process of examining important facts about the company such as:
● Information contained in publicly available financial statements and reports
● Established brand reputation and performance history
● Key management, leaders, and other support systems
● Inside stock ownership (indicating management’s confidence in the company’s future)
● Etc.
These qualitative factors could also be forward-looking such as news about a new product launch or acquisition.
2. Achieve a Margin of Safety
The margin of safety can be defined as the difference between a stock’s intrinsic value and its current market price. Ideally, the wider this gap is, the greater the investor’s margin of safety.
The logic behind having a margin of safety is that the investor’s estimation of intrinsic value will not be perfect. There is the risk that it may have been evaluated too optimistically or that the stock price may still have further to fall. In these cases, finding a security with significant margins of safety will help to minimize the risk of making a bad investment.
3. Have a Favorable Long-Term Outlook
Although the future is unknown, value investors will always attempt to pick prospects that have the greatest long-term potential. They will ignore current trends or hot new companies that are catching a lot of attention - even if they performing well in the stock market.
Instead, value investors prefer businesses that have a proven track record. They like to see consistency and wish for the company to continue operating in this way for decades to come.
This is especially true if the stock pays a dividend. A value investors want to be confident that the company they’ve picked will continue generating earnings and distributing those profits back into their hands.
4. Adopt a Contrarian Perspective
It can seem counterintuitive to invest in companies that everyone else seems to be ignoring. This notion can further be challenged when younger and more aggressive stocks are achieving double-digit or even triple-digit returns. However, value investors don’t mind going against the grain in this way.
Value investors want repeatable, long-term growth without a lot of volatility. They don’t want to gamble on companies with low (or no) earnings because it will expose them to too much unnecessary risk. While this might not be a fast or even exciting way to build a fortune, the value investor understands that over time the market will eventually reward those who were disciplined and patient.
This can best be summed up by a famous quote from Warren Buffett, “Be fearful when others are greedy and greedy when others are fearful.”
Common Characteristics of Value Companies
In general, securities favored by value investors tend to have the following popular traits:
● The company is large, established, and well-known. Some of the most popular value companies are market behemoths that have become common household names: Coke-Cola, JPMorgan Chase, ExxonMobil, etc.
● The stock has a relatively low beta. Beta is the measure of a security’s price movement relative to its benchmark. Value stocks tend to be less volatile and fluctuate less often than the overall market.
● The stock pays dividends. Instead of hanging on to earnings for itself, a value company will usually distribute profits back to the shareholders in the form of dividend payments. Dividends also assure investors that the company is operating well and profitable.
● Positive long-term growth outlook. There’s no reason to believe that the company will ever go bankrupt because they’re properly managed and offer a product that people will need for the foreseeable future.
Growth Investing vs Value Investing
Growth investing can be perceived effectively as the opposite of value investing. Rather than focusing on long-term stable returns, a growth investor looks for stocks that will deliver above-average returns; preferably in the short term.
This will generally be achieved through relatively new companies that have an optimistic outlook. For example, Amazon and Tesla were initially considered to be prime examples of growth companies because of their incredible year-over-year returns over such a short time period.
Even a large company like Apple was still considered a growth stock throughout the early 2000s as products like the iPod and iPhone generated impressive earnings. However, it should be noted that most large companies will eventually slow in growth potential as they become too large to increase at the same rate as they did in their earlier years.
Of course, the trade-off for potentially higher returns is taking on greater risk. Many growth companies have captured the attention and excitement of investors, but have failed to deliver on their promises. This was one of the major contributing factors to the Dot-com bubble that resulted in an economic recession at the beginning of the 2000s.
Other notable differences between value vs growth investing:
● Growth investors don’t mind buying stocks with relatively high P/E or P/B ratios. Some are even comfortable investing in companies that have not generated any earnings yet.
● Growth investors are willing to accept higher levels of beta. They understand that the prices of these stocks may fluctuate to a greater degree than the overall market.
● Growth investors aren’t necessarily expecting to own their securities for the long term. They will often move on once the company slows in growth or put their money into a more lucrative prospect.
● Growth investors are not concerned about whether or not the company pays a dividend. Most growth companies choose to invest their earnings back into the company, so they do not pay dividends to their shareholders.
Growth investing should not be confused with day trading. Day traders seek to exploit extremely short-term incremental price movements; sometimes buying and selling intraday. Meanwhile, growth investors (like value investors) will rely on more than just the price chart and perform their due diligence both quantitatively and qualitatively. They may hold onto the stock for months or even years awaiting the company to experience the explosive growth they believe it will achieve.
Avoid the Value Investing Trap
Although the goal of value investing is to find stocks trading at a discount, this should not be misinterpreted to say that they always look for those which are “cheap”. That’s a phenomenon that’s referred to as the “value investing trap”.
Anyone can find thousands of cheaply priced penny stocks that trade OTC (over the counter) instead of through a major stock exchange. However, these are companies that fail to meet U.S. SEC requirements and carry extraordinary risk. Therefore, to a value investor, it's likely that the grand majority of these companies would neither meet the criteria of having sound fundamentals nor long-term viability.
Even if a large company has a P/E ratio that’s currently lower than the trailing 5-year average, this is not always a signal to buy. Further investigation into the business’s financial documentation may reveal that it has taken on new debt, missed key earnings targets, or is otherwise at financial risk. An example of such a situation is with the now-defunct home appeal store Bed, Bath & Beyond.
This is why determining the company’s intrinsic value and performing fundamental analysis are so important in the process. Without them, the investor will be able to make decisions based on the whole picture.
The Bottom Line
Value investing is a strategy that involves buying companies at a bargain. It's based on a methodology that has largely been credited to Benjamin Graham and popularized in modern times by Warren Buffett.
Value investors will analyze potential prospects based on their intrinsic value in relation to the current market price. This is usually characteristic of companies with strong fundamentals, a good long-term outlook, and a reasonable margin of safety. Value investors also prefer to receive dividend payments from the shares they own.
Value investing takes a slow and steady approach whereas growth investing opts for more aggressive returns. Though the two methods differ in the types of companies they perceive to be as attractive, both take a thoughtful and well-rounded approach to review the stock's metrics as well as qualitative facts about the business.