There are no guarantees in the stock market.
The market can go up, down or sideways. You can’t outsmart or outguess the market. And you can’t know for sure which way an individual stock is going to go at any particular time.
People with crystal balls and time machines stop reading here.
However, one strategy that can help influence your long-term portfolio returns — value investing.
Value investing identifies stocks that are significantly “undervalued,” and prices that are anticipated to rise over time.
A value stock is considered undervalued when its price is well below its “intrinsic” or underlying value. It’s when you believe you’re getting a great deal in the world of investing.
The concept of investing in undervalued assets goes back a long time. Even in ancient times, merchants of all types understood that some assets are worth more than their current price. A lack of knowledge in the marketplace of what is real and true value creates an artificially low price. The savvy merchants would take advantage of this pricing discrepancy, buy low and sell high.
Value investing in its current form is traditionally traced to Benjamin Graham and David Dodd, finance professors at Columbia University, whose book “Security Analysis,” first published in the 1930s, set the standard for how to analyze the fundamentals of a company, and buy substantially undervalued stocks. Many editions later, the book is still studied in graduate schools of business around the world today. And its basic tenets have been adopted across the investment industry.
The basic concept was that, through analyzing a company’s current situation and future prospects, you can determine an “intrinsic value” of the company’s stock. Once you did that, you would purchase the stock only when its market price was well below this underlying value.
How the Value Investor Operates
Value investors look for companies that they believe, after analysis of the company’s situation and operations, are undervalued by the market and therefore have the potential to increase in price when the marketplace corrects its “error” in valuation and raises the price to an appropriate level.
This strategy doesn’t necessarily involve just buying any stock that has declined substantially in value. Some stocks deserve a lower price due to changes in their financial condition and prospects. In other words, they are not value stocks.
A good value investor does his homework to determine a company’s intrinsic value. He will invest in that stock only if its current price is significantly below what he believes is its underlying value.
Furthermore, the value investor usually leaves himself plenty of room in case he has overestimated the fundamental value of the company in question, or the situation changes significantly going forward. He does this by leaving himself a “margin of safety” – for example, only investing in a particular stock if its price is 25% or more below his estimated intrinsic value. This way, even if the stock rises only halfway toward his initial price projection, he will likely still be in the black with that stock.
Owning a Company, Not Just a Stock
Value investors, like the legendary billionaire investor Warren Buffett, see themselves not simply as buying shares of stock, but as becoming “owners” of businesses. In the case of Buffett, he has carried this viewpoint out by purchasing large percentages of companies he considers substantially undervalued, or in many cases buying entire companies. Indeed, his company, Berkshire Hathaway, is a holding company for, among other things, the many businesses that Berkshire has purchased using the value investing approach.
Because value investing is about determining the underlying value of a company and its stock over a period, value investors do not pay particularly considerable attention to short-term price fluctuations in the stock. They are likely to be in it for the longer term as buy-and-hold investors rather than as short-term traders.
How Do You Find Value Stocks?
Value stocks can be found in any market – the New York Stock Exchange, Nasdaq, over-the-counter, and markets in many countries around the world such as the UK, France, Japan, Germany, Norway or China. And they can be found in just about any industry, including energy, food, industrial companies, and even technology. They are more likely to be found in sectors that have become out-of-favor for one reason or another, for example, because the industry has been facing hard times or because they are likely targets of increased regulation.
Like most investors, value investors look to a variety of data and indicators to help them determine that a company is a value stock and is indeed significantly undervalued. In addition to a current market price substantially below the estimated intrinsic value (e.g., 25%-33% below), they may also look, for example, at companies with price-to-earnings ratios that are in the bottom 10% of all stocks in a particular market (e.g., the Standard & Poor’s 500 Index); a current ratio (current assets divided by current liabilities) of 2 or greater; a debt-to-equity ratio of less than 1; and a PEG ratio of less than 1. (The PEG ratio is calculated as the price-to-earnings ratio divided by its year-over-year earnings growth).
The Value Investing Bottom Line
Many investors use value investing as one of the foundation pillars of their investment strategy and earn substantial returns by buying and holding until the market price catches up with their estimate of the stock’s intrinsic value.
They may have a diversified portfolio of value stocks – across different industry sectors, for example, or across the US and foreign markets – to help minimize their investment risk even further.
Sometimes, however, their analysis may be wrong, or their expectations for a particular company may not materialize, or the competitive environment in which the company operates may change dramatically; for example, a new competitive product enters the market and shifts the company’s outlook sharply.
In such cases, the investor may have to take his loss – or a very minimal gain — on that company. But if he has done his homework and has diversified his portfolio, value investing will likely put him ahead of the game in the long run.
You may wish to consider value investing as a foundation for your stock market activity. If you do, we can help you establish an investing framework that will fit with your overall portfolio and financial planning strategy.