Value investing is a bargain-hunting strategy that targets low-performing but quality stocks, aiming to profit when their prices rise again
- Value investing consists of finding and buying stocks that are priced below their companies' intrinsic worth, or true value.
- The value investing approach involves researching a company's fundamentals, examining its earnings and assets in relation to its stock price.
- Though eclipsed lately by flashier growth investing strategies, value investing remains a good way to diversify and hedge against losses.
Value investing is an investment strategy that involves buying stocks that are underpriced compared to market averages. Rather than targeting the most hyped or best-performing equities, it seeks out neglected stocks in the hope that the market will realize the errors of its ways and belatedly start to push up those shares' prices.
Value investing has long been used by investors seeking to find bargains that eventually provide a big return, but it has become less profitable in recent years. However, by allocating a proportion of your portfolio to value stocks, you may be able to hedge your risks and cushion losses during downturns.
What is value investing?
As its name suggests, value investing is about finding, researching, and buying investments that are priced below their intrinsic worth - their true value.
"Value investing usually means a style of investing that looks for companies that seem truly unloved. These companies tend to be in undesirable or slow-growing areas, with a low price relative to recent profits and their ratings appear much lower than the market average," says Susannah Streeter, a senior investment and markets analyst at Hargreaves Lansdown.
The strategy was developed in the 1920s at Columbia Business School by finance educators Benjamin Graham and David Dodd, who both believed the intrinsic value of a stock should be determined through research of the company's fundamentals, not the anticipated reactions of the market.
Among Graham's most well-known students? Warren Buffet, who made his fortunes by being a loyal practitioner of value investing.
At its core, value investing is all about buying low and selling high. In practice, the approach works under the premise that with enough patience, a company's intrinsic value and market value align, resulting in big future gains.
Value investing vs. growth investing
Value investing is more or less the flip side of growth investing. Rather than buying companies whose stock is already rising fast, value investors buy companies that are cheap because other investors have decided they aren't worth much.
Growth investors tend to be younger with a bigger appetite for risk, while value investors are proportionally more likely to be older. They also tend to possess higher financial and real estate wealth, indicating that they don't need to take so many risks on growth stocks. And because value investors are often closer to retirement or retired, they usually prioritize a steady income over quick gains, focusing on stocks that also provide dividend payments in addition to being undervalued.
Evaluating a company's intrinsic value
There are many metrics investors use to determine the intrinsic value of a stock, all of which deal with scrutinizing company accounts, in order to unearth financial information which indicates that a company's stock price isn't an accurate assessment of its overall worth.
As a starting point, beginner investors seeking value can look at:
- Price-to-earnings ratio: the ratio of a company's share price to its earnings per share
- Price-to-book ratio: the ratio of a company's share price to its book value (its assets minus liabilities)
"The value investing approach relies heavily on company accounts and trying to establish the value of a company compared to its current price. The price-to-earnings ratio is a key indicator as is the book value of a firm's assets," says Streeter.
While average price-to-earnings ratios will vary over time, the S&P 500's P/E ratio passed 30 in 2020, meaning that you'd spend $30 for every $1 of profit the companies in the index earn (on average). It had been just above 20 in 2019 and was as low as 13 in September 2011.
However, Streeter says that the subtle art of identifying value stocks has become harder in recent decades, largely because company assets have become more intangible in a digital, information-based economy.
"Instead of factories and machinery, today's valuable assets are more likely to consist of data sets, software, brands, and even ideas. Not accounting for these could throw investors off the scent of stocks with great scalability potential or could lead them to snap up what they see as bargain value stocks with little prospect of recovery," she adds.
When investing for value, it's also important to learn how to distinguish between companies that have been neglected because the markets have made a mistake and those that are neglected because they're in serious trouble.
"The key thing when choosing value stocks is to make sure they've not been priced cheaply because they're on their way to bankruptcy. Check their debt levels, how much free cash flow they have, and also their price-to-book ratio, which tells you how the share price compares to the value of the company's assets," says Glen Goodman, an investment expert and former TV business correspondent.
How to find value stocks
As with equities investing in general, you have two main options for investing in value stocks.
Your first option is to identify value stocks yourself and invest in them individually. You can do this using one of the many investment platforms or apps now available, such as Robinhood, Betterment, Fidelity Go, Acorns, Investr, E*TRADE, and so on. Alternatively, you can also use an investment broker, such as Fidelity Investments, TD Ameritrade, and Charles Schwab.
Secondly, you could invest in one of the many mutual funds or ETFs which target value stocks. Some of the largest, in terms of assets under management.
Value ETFs:
- iShares Select Dividend ETF
- iShares MSCI EAFE Value ETF
- Utilities Select Sector SPDR Fund
- Vanguard Utilities ETF
- Vanguard Energy ETF
- Invesco KBW Bank ETF
- Fidelity MSCI Utilities Index ETF
Value mutual funds:
- Bridge Builder Large Cap Value
- T. Rowe Price Small-Cap Value
- Vanguard Equity Income Fund
- Dodge & Cox Stock
- Eaton Vance Focused Value Opportunities Fund
- Vanguard Windsor II Fund
Assuming that you have found a genuine value stock, investing in it should ultimately result in profits somewhere down the line. If a stock is currently priced at $20, but you've calculated that it should be priced at $80, then you'll make $60 merely by holding it and waiting for the market to catch up with reality.
This may take several, even many years to happen, but this is essentially how such famous investors as Warren Buffett, Charlie Munger, Seth Klarman, and Joel Greenblatt have made their names over the years.
The strategy does involve patience and perseverance. But if you've carefully weighed up a company's fundamentals, then you should be able to hold firmly to the assurance that the market will, sooner or later, realize its fair value.
Tips for investing for value
Value investing used to be a dependable and safe strategy for growing your assets steadily over time. But this has changed substantially in recent years, as the market and economy have shifted to an increasing focus on growth stocks and the companies issuing them.
"The main reason value has under-performed lately is that many financial stocks have been languishing ever since the 2008 financial crash, while the big tech stocks have been conquering the world," says Glen Goodman.
That said, there are a number of principles an investor should adopt if they want to increase their chances of making a profit when value investing.
Strike a balance: Diversification is possibly the most important strategy any investor can take, regardless of their particular focus. The same goes for value investing, which should be viewed as a means to diversify, rather than a standalone strategy in its own right.
"Adding value-investing into your mix will not necessarily make you more profitable, but it may … help smooth out your investment returns. For example, if you invest half in growth stocks and half in value stocks, when the big tech stocks plunge, your growth portfolio could take a big hit, but your value stocks may outperform, helping to cushion the blow to your overall portfolio," says Goodman.
Focus on research: Value investing is the one area where research of a company's fundamentals is absolutely necessary. With growth investing you really can follow the herd almost, but the whole idea of value investing is that you're spotting something others have missed, so it implies a considerable amount of research and homework.
This means poring over a company's financial statements, its balance sheet, its assets, its liabilities, its returns, its growth, and so on.
Be patient: As mentioned above, the likes of Warren Buffett and Charlie Munger profited from value investing by holding onto value stocks for years, with Buffett holding Coca-Cola for 32 years now. It really is a long-term strategy, so don't buy value stocks unless you're prepared to sit tight and wait.
This implies shrugging off slow growth, as well as resisting the urge to sell up and splurge on some seemingly more attractive growth stocks.
Be prepared to buy the dip: Returning to Buffett, it's worth noting that he bought his shares in Coca-Cola following the 1987 stock market crash. This is a tactic used widely by value investors, who pounce on market crashes to buy otherwise strong stocks on the cheap. As such, it may be worth holding some cash in reserve for just this possibility.
The financial takeaway
At the present moment in history, value investing has become more of a supplementary strategy, one which will help diversify your portfolio and hedge against risk. It has demonstrated good results in past decades, but the market focus on fast-rising growth stocks now means that some apparently underpriced stocks don't ever rise to their "real" value.
Nonetheless, it may still be worth investing in stocks that truly are undervalued compared to the rest of the market, although you will need to do your research. At the same time, the dominance of tech and other growth stocks may run its course, so it's probably wise to keep value investing in your toolkit.
"No sector and no strategy outperforms forever, so at some point, value is sure to have its day in the sun once again," says Glen Goodman.