Value investing is an investment strategy focused on finding and buying financial securities below their intrinsic value. While it’s often applied to the stock market, where mispricing is prevalent, value investing can be deployed across any asset class, such as bonds, real estate, and alternative investments.
How does value investing work?
The stock market can be a volatile place, with shares being shifted up and down based on short-term catalysts such as earnings reports, legal disputes, geopolitical issues, and macroeconomic policy, among countless other factors.
Value investors seek to profit from this volatility. They spend time researching to identify strong businesses with promising long-term potential. And then only buy shares when the stock price falls significantly below intrinsic value due to short-term problems or concerns.
There are various methods for calculating intrinsic value. And Multiples, as well as Discounts Cash Flow Models, are the most popular. Over long periods, other investors may eventually recognise the hidden value, pushing the share price up. This is why stocks, in the long run, always follow the performance of the underlying business.
However, the time for this recognition of value can vary greatly. It could be a few months or even years. And that’s why value investing requires significant patience for an investment thesis to play out. And that’s assuming the investor was correct in finding hidden value in the first place.
Suppose a value investor cannot hold onto their shares long enough for the valuation to eventually correct itself. In that case, they could likely end up losing money. Therefore, while adopting a value investing strategy enables investors to ignore a lot of the short-term financial noise, there’s still no guarantee of positive returns.
Nevertheless, adopting this investing style can be highly lucrative. Arguably the world’s most famous value investor is Warren Buffett, who built his entire ~$110bn fortune using this approach.
What are the five value investing principles?
At the heart of value investing lies five core principles that most value investors follow:
- Business – Value investors only focus on high-quality enterprises with proven business models, established industry positions, robust financials, and talented management. This often means investing in mature companies. While the growth is less explosive, it also reduces risk as these firms are less likely to be disrupted in the long term. However, there are never any guarantees.
- Valuation – Regardless of how impressive a company is, value investors will never buy shares if the price isn’t right. Even a top-notch corporation can be a lousy investment if an investor overpays for its shares. That’s why the value investing strategy only considers stocks trading significantly below their estimated intrinsic value. In other words, buy low, sell high.
- Dividends – While not a strict requirement, most value investors prefer stocks with a well-funded and reliable dividend. It can take years for an undervalued stock to be recognised by the market. But if dividends are paid, investors can capitalise on higher dividend yields, amplifying their returns and providing a steady stream of passive income while they wait for the stock price to increase.
- Growth – Investing in established mature companies isn’t the greatest source of growth. However, even a mild expansion of operations can be lucrative if consistent. A business capable of delivering some growth to its cash flow can accelerate the process of other investors recognising its intrinsic value as well as potentially result in an expanding dividend.
- Diversification – Even if an investor follows all the steps correctly, it’s still possible for a value investment to go south. For example, after identifying an undervalued stock, a new development permanently compromises the firm’s cash flow, making a stock price recovery unlikely. That’s why diversification plays a vital role. Owning shares in multiple companies across different industries and geographies can mitigate the impact of a bad investment on a portfolio.
How to pick value stocks?
Learning how to pick stocks can be a daunting task. After all, the process is vastly different depending on the investing strategy used. And there are a lot of factors to consider.
When picking value stocks, investors are focused on the fundamentals, extensively researching and analysing every company’s characteristics and financial statements. Some examples include:
- Track Record – A company with a reputation for quality and prudent leadership is more likely to deliver long-term shareholder value than a firm suffering from poor leadership or bad capital allocation.
- Financial Health – Regardless of how innovative a firm’s product or service may be, it’s ultimately irrelevant if the company is struggling with liquidity and solvency issues. A careful analyst of the balance sheet and other financial statements can provide valuable insight into the financial health of a firm.
- Future Strategy – A leading business today likely won’t stay that way if management doesn’t have a viable or realistic strategy for long-term growth.
- Sustainable Dividends – For value investors interested in reaping dividends while waiting for a valuation to correct itself, it’s essential to ensure a company generates sufficient cash flow to maintain and expand shareholder dividends in the long run.
- Industry Trends – Some companies operate in cyclical industries. Even if the stock price is undervalued, investing near the cycle’s peak can still lead to a poor-performing investment.
Key metrics and ratios
- Earnings Before Interests and Taxes (EBIT) – Provides insight into a company’s core earnings without the influences of interest payments on debt and taxes.
- Earnings Before Interests, Taxes, Depreciation, and Amortization (EBITDA) – Sometimes referred to as underlying earnings, EBITDA looks at a firm’s EBIT after excluding the non-cash effects of depreciation & amortisation. This is a closer reflection of a company’s cash flow.
- Debt-to-Equity Ratio – Compares the balance of debt to equity on the balance sheet to provide insight into a firm’s solvency. A higher value can suggest a business is overleveraged, potentially compromising financial health.
- Price-to-Earnings (P/E) Ratio – Compares the share price to the earnings per share. Comparing the P/E ratio to the industry average can provide a rough estimate of whether a stock currently trades at a discount or premium valuation.
- Price-to-Book (P/B) Ratio – Similar to the P/E ratio, the P/B ratio compares a share price to the book value of a firm’s assets. This can provide more helpful insight into the valuation of asset-based businesses such as real estate.
- Price/Earnings Growth (PEG) Ratio – This ratio is an extension of the P/E ratio that also factors in the expected future growth of earnings. It can provide a more meaningful insight than the P/E ratio alone. However, this metric relies on forecast earnings growth that may be inaccurate.
What’s the difference between value investing and growth investing?
Both growth investing and value investing share characteristics. However, the two strategies also have some stark contrasting differences.
Under the growth investing philosophy, investors seek to find companies that are still in, or about to enter, the growth stage of the business cycle. This can lead to significantly higher returns if a company is successful. However, a growth stock will often trade at a significant premium because of the higher potential for explosive returns.
Combining younger businesses with premium valuations opens the door to significantly higher risk. And often, these firms fail to live up to expectations resulting in lacklustre or even negative returns.
Despite the increased risk, growth investing can still be immensely profitable, providing investors can identify future long-term winners. For example, a $1,000 investment in Apple shares in 2002 following the Dot Com stock market crash would now be worth approximately $648,000.
The decision to adopt a value investing or growth investing strategy ultimately depends on an individual’s investment goals and risk tolerance. However, it’s not uncommon for investors to blend a combination of value stocks and growth stocks within an investment portfolio.
Performance of value stocks
When looking over long time horizons, value stocks have historically outperformed growth stocks. And not by a small margin. According to Bank of America, value investing has generated returns of over 1,344,600% since 1926. By comparison, growth stocks have only mustered a 626,600% return over the same period. And a large contributing factor between the two returns is dividends.
According to Polaris Capital Management, value stocks have, on average, outperformed growth stocks by 4.54% annually in the United States.
However, in recent years this pattern has changed. Between 2007 and late 2020, growth stocks vastly outperformed value stocks, with tech stocks leading the charge.
Famous value investors
Throughout history, there have been many successful value investors. And some of the most prominent include:
- Benjamin Graham – Considered to be the father of value investing, Graham taught many investors, including Warren Buffett, how to identify companies trading below their intrinsic value.
- Warren Buffett – Considered by many as one of the greatest investors of all time, picking high-quality stocks that are trading below their intrinsic value and holding them for decades.
- Joel Greenblatt – He is one of the foremost experts on value investing.
- John Neff – He is a textbook value investor. He considers companies with low price-earnings ratios.
- Monish Pabrai – He is well known to be following Warren Buffett’s investment strategies.
The bottom line
Value investing is a proven investment strategy for achieving long-term portfolio growth and often comes with a steady stream of passive income from dividend shares. This investing style requires a strong understanding of corporate analysis and valuation, as well as demands a lot of patience.
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This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment is dependent on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor must consider their individual financial circumstances and reach out to an independent financial advisor if necessary.