Value stocks are the shares of businesses that are trading below their fair intrinsic value. And investors capable of identifying these investment opportunities can unlock significant portfolio returns.
This approach lies at the heart of the value investing strategy. And it’s how famous investors like Benjamin Graham and Warren Buffett built their fortunes. In fact, Graham is regarded as the father of value investing, postulating his work in various books, including The Intelligent Investor and Security Analysis.
What is a value stock?
A value stock is a stock that’s trading at a market price which is below the underlying firm’s intrinsic value derived from its fundamentals. Despite the stock market being relatively efficient, valuations, in the short term, are driven by mood and momentum. And due to novice investors’ irrational, emotionally-driven decision-making, value and price are often divorced.
A common example of this is when a company misses its earnings target due to an unforeseen temporary disruption. This can send a share price firmly in the wrong direction in the short term. However, in the long run, the business naturally resolves its issues and gets back on track resulting in a steadily recovering share price.
Value stocks are often thought of as mature well-established enterprises. However, this isn’t necessarily the case. In reality, even growth stocks can occasionally enter value territory if share price volatility leads to firms trading under their intrinsic value.
How to identify a value stock?
Like any investment strategy, there are a lot of factors to consider when searching for value stocks. And the importance of each element can change drastically between industries and even geographies.
Having said that, several common characteristics value investors often search for when hunting for bargains. These include:
- Ability to generate long-term profits
- Service loan obligations
- The capability of maintaining dividends or share buybacks
- Book value
- Earnings growth
- Level of risk exposure.
But there are more nuanced indicators to consider.
- Market & Industry Trends – Searching for bullish or bearish trends of companies within popular and unpopular industries can lead to discovering high-quality value stocks.
- Past Performance – Past performance is a poor indicator of future returns. But, it can provide valuable insight into the skill of a management team as well as the quality of a business model. A firm with a consistent track record of delivering growth and value to shareholders is more likely to continue doing so than a business with an erratic financial history.
- Forecast cash flow – Companies, brokers and analysts often issue forecasts of where they believe revenue and earnings are likely to go in the future. Forecasts need to be taken with a pinch of salt. However, they can help identify potential bargains in the stock market. A firm currently suffering from short-term disruptions is likely to see its stock price suffer. However, a buying opportunity may have emerged if the long-term outlook remains uncompromised.
- Competition & Risk of Disruption – Businesses that own many competitive advantages are less likely to become disrupted, even when a new competitor enters the arena that puts other investors on edge. This may result in a firm’s stock price dropping even when the threat is mild.
How does Warren Buffett pick value stocks?
As the world’s most famous value investor, Warren Buffett is followed and studied by many fellow value hunters in an attempt to find bargains. Despite his enormous level of success, Buffett’s investing strategy is relatively simple: buy wonderful businesses at fair prices.
He looks for firms with proven business models, a vast moat of competitive advantages, talented management teams, strong financials, and an attractive stock price.
Obviously, a lot of research and work is involved in finding such opportunities in the stock market. However, Warren Buffett shares valuable insight into his investing approach yearly in the Berkshire Hathaway shareholder letters.
Advantages of value stocks
Value investing provides patient investors with several significant advantages that can substantially accelerate the wealth-building journey.
- Lucrative Returns – Shares of high-quality businesses bought at cheap valuations have the potential to offer massive returns in the long run.
- Reduced Volatility – No investment is risk-free. However, an investor buying shares in a business already significantly trading below its intrinsic value is less likely to fall drastically compared to a growth stock trading at a premium valuation. This can reduce an investment portfolio’s overall volatility without compromising potential returns.
- High Long-Term Dividend Yield – The dividend yield on a stock naturally increases whenever the share price falls. Providing that dividends can be sustained by underlying free cash flow, this can lead to a higher level of passive income for value investors. Moreover, a high-quality business is more likely to increase dividends in the future, pushing the yield at a cost-basis even higher over time. In fact, this is how Warren Buffett’s original investment in Coca-Cola provides his portfolio with an annual dividend yield of over 54%!
Disadvantages of value investments
The benefits of value investing are undeniably attractive. However, this investment strategy is not free from disadvantages.
- Requires Skill – Corporate valuation is a challenging process that is notoriously difficult. Estimating intrinsic value requires a strong understanding of financials, industry analysis, revenue forecasting, and discounted cash flow model construction. Even Warren Buffett has made costly valuation mistakes leading to terribly performing investments. And investors with an improper skill level can unknowingly enter value traps that destroy wealth rather than create it.
- Requires Patience – Even if an investor successfully identifies a terrific business trading at a discount, it could take a long time for the rest of the stock market to agree. Therefore, value investors can often be left waiting months or even years for an investment thesis to play out. For naturally impatient investors, hunting value stocks will likely be an unsuccessful venture.
Value stocks vs growth stocks
Another popular category of shares in the financial markets is growth stocks. These types of equities often trade far beyond the underlying firm’s intrinsic valuation and are prone to significantly higher levels of volatility. So why are they popular?
Growth investors are often willing to pay substantial premiums for businesses with enormous long-term potential. While there are never guarantees, several growth stocks throughout history have delivered impressive stock returns, turning tiny investments into multi-million dollar fortunes.
For example, if an investor bought $1,000 worth of Apple shares in 1985, their investment would be worth roughly over $2.2m at the end of 2021.
As exciting as this prospect sounds, it’s worth pointing out that for every Apple, there have been hundreds of companies that ultimately failed to deliver. As such, growth investing is typically more appropriate for investors with a higher risk tolerance.
Should I invest in growth or value stocks?
Determining which types of stocks to buy ultimately depends on an investor’s goals, time horizon, and risk tolerance. Additional personal characteristics need also to be considered.
As previously mentioned, value stocks require tremendous patience that not every investor posses. Similarly, a growth stock can often experience bouts of extreme share price volatility that not every investor is comfortable with.
Often an investment portfolio will be constructed using a combination of the two types to spread the risk and enjoy the benefits of both investing strategies. Regardless, neither growth nor value stocks guarantee positive investment returns.
Other types of stocks
While value and growth stocks often get most investors’ attention, multiple alternatives exist.
- Income Stocks – Shares that provide investors with a stream of (hopefully) reliable and consistent passive income through dividends.
- Defensive Stocks – Shares of companies that operate in defensive industries less susceptible to economic fluctuations. Defensive stocks have historically outperformed during bear markets but underperformed during bull markets.
- ESG Stocks – Shares of businesses that seek to add value to society, the environment, and employees while still generating positive returns for investors. ESG stocks are typically hunted by investors who want to build an investment portfolio that aligns with their personal morals and ethics.
The bottom line
Buying and holding value stocks is the heart of the value investing strategy. Investors who can successfully identify shares trading at a discount to the intrinsic value of their underlying company can unlock superior market-beating returns. However, this investing style requires a high degree of analytical skill and patience, potentially making it unsuitable for some investors.
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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.