Value Investing Defined
Value investing is the practice of purchasing stocks that are trading for less than their intrinsic value. The idea is to buy the stock when the price is temporarily low and realize gains when it recovers. Value investing can be more casually described as buying stocks on sale.
The strategy relies on a few assumptions about market behavior and investing, including:
- Investors don't always act rationally. The investment community can respond dramatically to bad news or good news, pushing the stock price higher or lower than it should be. The savvy value investor who keeps a level head can profit from these swings in market sentiment.
- Irrational market pricing is temporary. It may take months or years, but overly high or low stock prices eventually moderate to reflect the business' true value.
- Business value is quantifiable. Value investors rely on metrics and financial analysis to determine a company's intrinsic value.
- Good companies eventually prove their worth to the market. Enduring competitive advantages and strong leadership teams are two characteristics of good companies.
- Long-term compounding is the surest route to building wealth in the stock market. Value investors don't seek quick gains from frequent trading. They look to profit from long-term compounding, so they favor long holding periods.
Value Investing Strategies
Key value investing strategies to understand are fundamental analysis, quality investing, contrarian investing and dividend investing. Let's look at each one below.
1. Fundamental Analysis
Value investors use fundamental analysis to understand a company's intrinsic value. This analysis can take different forms, but most often includes an income statement review relative to competitors, a balance sheet review and comparative analysis of free cash flow performance plus valuation metrics.
Income Statement
Value investors want to see a history of operating profits, which is earnings generated by core business activities. Operating profit is a measure of how effective the business model is, without extraneous line items like interest income and interest expense.
High margins relative to competitors are ideal since profit efficiency can be a compelling competitive advantage.
Balance Sheet
The balance sheet should demonstrate stability. A good value prospect must be able to pay its obligations in the short- and long-term. Value investors can assess this ability by reviewing metrics like the working capital ratio and the debt-to-equity ratio.
- Working capital ratio or the current ratio is calculated by dividing current assets by current liabilities. The metric indicates how well the company can cover its accounts payable, short-term debts, accrued expenses and other immediate payables from its cash, accounts receivable and inventories.
- Debt-to-equity ratio measures the company's reliance on debt. You calculate debt-to-equity by dividing shareholders' equity into total liabilities.
Free Cash Flow
Free cash flow is the cash remaining after the company funds its operations and capital expenditures. If a company pays dividends and/or buys back shares, free cash flow funds those activities.
Value investors want to see a history of consistently increasing free cash flow. Rising free cash flow coupled with a sluggish stock price can signal solid returns ahead for shareholders.
Valuation Metrics
Valuation metrics are comparable ratios that help you identify whether a stock is trading for more or less than it's worth. Two critical metrics to know are price-to-earnings (PE) and price-to-book (PB).
PE Ratio
You would calculate PE by dividing the company's earnings per share (EPS) into its stock price. You can use the prior year's EPS or the forecasted EPS for the next 12 months. When you use the forecasted EPS, the resulting number is called the "forward PE."
The PE ratio tells you the current cost of each dollar the company earns. A lower PE ratio compared to a similar competitor indicates a possible bargain—since you'd be paying less for the same amount of earnings vs. the competitor.
PB Ratio
The PB ratio compares a company's market valuation to the value of its assets less liabilities, also known as book value. To calculate the PB ratio, divide the stock price by the book value per share.
For the value investor, a PB ratio of less than 1 indicates the stock could be undervalued.
2. Quality Investing
Quality investing focuses on companies with conservative balance sheets, experienced leadership and a track record for growing cash flow. Often, the company's long-term success is related to one or more competitive advantages, such as scale and high margins, unmatched market penetration or an unshakeable brand reputation.
Blue-chip stocks and premier dividend payers tend to be suitable picks for the quality-focused investor.
Quality stocks have lesser growth potential compared to smaller, younger organizations. As a result, investors can overlook them in favor of more exciting assets. This can lead to undervaluation. The flip side, though, is that quality stocks hold their ground better in downturns vs. less mature companies.
3. Contrarian Investing
Contrarian investing goes against the grain: You buy when others are selling and sell when others are buying. Famous value investor Warren Buffett once described his own contrarian approach this way, "We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful."
Hedge fund manager Bill Ackman famously made more than $1 billion with a contrarian view of bond insurer MBIA in the early 2000s. Ackman saw too much risk in MBIA's exposure to mortgage derivatives. In 2002, he began investing in the company's failure by way of credit default swaps and a leveraged short position.
MBIA's stock crashed in 2007. In 2009, Ackman disclosed he'd closed out his MBIA position with a profit of $1.4 billion.
As Ackman's experience demonstrates, betting against the masses can be profitable, but it requires patience. The process involves identifying trends the investment community at large doesn't yet acknowledge, investing in those trends and then waiting for the prevailing viewpoint to change.
4. Dividend Investing
The qualities of the best dividend stocks overlap with the qualities of strong value stocks. These include a proven business model, ample cash flow and leadership team that's dedicated to rewarding its shareholders.
Premier dividend stocks are characterized by a decades-long history of increasing dividends. So-called Dividend Kings, for example, earn the title by raising dividend payouts annually for the most recent 50 years. That's an accomplishment that cannot be achieved without a business that consistently produces rising cash flow—a requirement for a good value stock.
The brain trust at Forbes has run the numbers, conducted the research, and done the analysis to come up with some of the best places for you to make money in 2024. Download one of Forbes' most popular and widely anticipated reports, 12 Best Stocks To Buy for 2024.
Tips for Successful Value Investing
Value investing is tricky. At the core of that trickiness is the subjectivity of value. Yes, valuation analysis is rooted in metrics, but the numbers must be interpreted in context. Interpretation is subjective and business context is fluid. Competitive environments and economic conditions are always changing.
As well, a key component of value is the business's outlook, which is also subjective. A company with low PE and PB ratios is only a good value stock if the business can grow. Without reasonable growth prospects, a cheap stock is just a cheap stock, not a value play.
So value investing isn't an exact science, which is why you should build a few defensive strategies into your approach. Consider implementing a minimum margin of safety, diversifying your portfolio, focusing on the long-term and avoiding emotional decisions.
1. Invest in Companies With a Margin of Safety
Margin of safety is the difference between a stock's price and its intrinsic value. The larger the margin of safety, the more protection you have against being wrong in your value assessment.
If you think the stock should be priced at $100 and you buy it for $90, you have a 10% margin of safety. That doesn't leave much room for error. The best stocks to buy will give you a larger margin of safety.
Decide on a minimum margin of safety for your value stocks. Twenty percent is a good starting point. You can adjust it up or down based on your experience.
2. Diversify Your Portfolio
Diversification is another way to insulate yourself against being wrong about a stock or its outlook. By holding a varied group of stocks, you ensure that no one of your assets can sap your wealth.
Make it a practice to hold 20 individual stocks at one time. As much as possible, choose stocks that have different risk characteristics. You can do this by investing across industries, market capitalizations and currencies.
3. Have Patience and Focus on the Long-term
It can take years for the market to reprice an undervalued company. This is a critical truth to understand: Value investing requires patience, before and after you buy.
With your prospective value stocks, you may have to wait until a market downturn brings the stock price down to satisfy your margin of safety requirements.
Once you buy the stock, you may have to wait years to see the value you expect. The good news is that value stocks generally withstand the test of time, as long as the business fundamentals don't deteriorate.
4. Avoid Emotional Decisions
Market extremes happen when emotions take over. Market crashes are driven by fear and stock market bubbles are driven by greed.
If you can stay calm and resist the herd behavior—which is easier said than done—you can find gains in those market extremes. On the other hand, following the masses increases the chances that you'll buy high and sell low. That is not a sustainable investing formula.
The brain trust at Forbes has run the numbers, conducted the research, and done the analysis to come up with some of the best places for you to make money in 2024. Download one of Forbes' most popular and widely anticipated reports, 12 Best Stocks To Buy for 2024.
Best Practices For Implementing A Value Investing Strategy
When you're ready to give value investing a try, start by defining your process. The more you can operationalize your investing, the easier it will be to keep emotions out of your decision-making.
A good process should include building a watchlist, conducting research and analysis, monitoring your investments closely and rebalancing your portfolio as needed.
Build A Watchlist of Potential Investments
Your watchlist consists of companies that are potential value plays, but don't yet satisfy your investing requirements. The stock price might be too high, or you might be uncertain about the company's growth outlook.
Monitor the stocks on your watchlist so you can quickly identify when circ*mstances change. This approach is particularly useful for stocks that don't meet your margin of safety requirement. The stock price might suddenly dip based on external factors, which could be your buying opportunity.
Conduct Thorough Research and Analysis
Research and analysis are essential to the value investor. Define the qualities you need to see in your value stocks and establish your own research-based screening process.
Monitor Your Investments Closely
The research doesn't end when you open a position. You must continue to monitor your value stocks over time, because circ*mstances can change and companies can lose their way. If a stock no longer suits your parameters and you believe the change is permanent, close it out and move on.
Rebalance Your Portfolio as Needed
Rebalancing is the practice of resetting your portfolio to a target composition. Your portfolio composition naturally changes over time as some positions grow faster than others. Left unchecked, this process can leave you overweight in a single stock or industry.
Keep an eye on your portfolio composition over time and rebalance as needed to manage your overall risk.
Value Investing FAQs
What is the difference between value investing and growth investing?
Value investing involves seeking out stocks that are undervalued by the market and have the potential for long-term growth. Growth investing focuses on companies with high growth prospects in the short-term.
How do I identify value stocks to invest in?
Some common metrics to use when identifying the best value stocks include the PE ratio, PB ratio and dividend yield. You can set your own parameters for these values and then use a stock screener to find potential assets.
Is value investing still effective in today's market?
Yes, value investing can still be effective in today's market. It does require careful research and analysis to identify truly undervalued companies.
What are some common mistakes to avoid when implementing a value investing strategy?
Common mistakes to avoid when implementing a value investing strategy include overemphasizing short-term fluctuations, failing to diversify your portfolio and investing in companies with minimal growth prospects or poor business fundamentals.
When does value investing perform best?
Value investors can find their best bargains in market downturns, economic recessions and industry-specific contractions.
While the growth trajectory of value stocks varies by company and industry, these bargain stocks can perform well in the earlier phases of economic expansion. As expansion continues, though, increasingly confident investors will begin favoring growth stocks instead.
Is value investing for me?
Value investing is suitable when you have a long investing timeline and a practical mindset. You might have a love for finding bargains, plus a knack for analyzing things through your own lens. Additionally, you're not swayed by what everyone else is doing or enamored with the idea of investing in "the next big thing."
In investment terms, this describes a contrarian who’s comfortable with fundamental analysis and patient enough to wait for good buying opportunities and long-term gains.
The brain trust at Forbes has run the numbers, conducted the research, and done the analysis to come up with some of the best places for you to make money in 2024. Download one of Forbes' most popular and widely anticipated reports, 12 Best Stocks To Buy for 2024.
