Value investing is a popular strategy that involves buying stocks that appear to be 'on sale', based on an objective analysis of their intrinsic value. Read on for the strategy's pros and cons and how to get started.
What is value investing?
Value investing is a very popular strategy involving buying stocks that appear to be trading for less than their intrinsic value. Value investors consider that the market often overreacts to both good and bad news, resulting in company stock prices lurching away from their fundamentals.
An overreaction towards bad news, therefore, offers investors the chance to 'buy the dip' before the correction upwards.
Famous and successful proponents include the Sage of Omaha Warren Buffett, in addition to Benjamin Graham, Charlie Munger and Seth Klarman. Graham – together with David Dodd – were the forefathers of the concept when they began research into the phenomenon in the 1920s while teaching at Columbia Business School. Buffett was a student of Graham for several years and has been significantly influenced by his former professor.¹
There are two key factors to bear in mind when considering deep value investing:
- investors view themselves as part 'business owners' rather than as traders, valuing companies on their financial statements by way of fundamental analysis
- the calculated 'intrinsic value' will usually rely on many assumptions when valuing a business, so it will likely fall into a range rather than an exact figure. These assumptions may not always be right
Value investing vs growth investing
Investors often confuse the two strategies, but there are marked differences between a value investing strategy and growth investing. The key difference is that value stocks are companies that investors think are undervalued by the market, while growth stocks are companies that investors think will deliver better-than-average returns.
- currently undervalued
- low P/E ratios
- high dividend yields
- currently overvalued
- higher P/E ratios
- low/no dividend yields
Another difference is in the type of risk. Value stock investing involves the risk that the stock may not appreciate as much as expected, while growth companies are usually highly volatile with a relatively high rate of failure.
How value investing works
Understanding the mindset behind value investing is actually very simple. If you know the true value of something, then you can save money when buying it 'on sale'. This applies to every purchase, from groceries to electronics to housing. For example, whether you buy a jacket at full price in the run-up to Christmas or half-price in the January sales, you’re still getting the same jacket.
Buying stocks is the same – a company's share price will fluctuate (sometimes drastically), even though the underlying fundamentals remain the same. Of course, it's harder to buy stocks 'on sale', as the sale price isn't advertised. Investors need to do some detective work to discover which stocks are trading 'at a discount' as a value investment.
Even then, there's no guarantee that buying shares will yield a return.
This detective work involves using several metrics to attempt to find out the intrinsic value of a stock. This involves combing standard financial analyses of revenue, cash flow, earnings and profit with fundamental factors such as brand power, the business model, the target market and the so-called 'economic moat' of competitive advantage.
The most popular metrics include:
- price-to-earnings (P/E) – which reflects the company's track record to decide whether the stock price reflects its earnings. The lower the ratio, the more likely it is that the company is a value stock
- price-to-book (P/B) – which sums up the total value of a company's assets, then compares this figure to the stock price. If the stock is trading for lower than its total assets, then the company may be undervalued
- free cash flow – which is cash generated from revenue after expenditure costs. Expenditure costs extracted include day-to-day operating expenses and one-off purchases, called capital expenditure (CAPEX). Positive free cash flow indicates that a company has the capital to grow, reinvest, pay off debt, pay dividends or similar²
Of course, there are many other metrics to consider, including total equity, debt, overall sales and revenue growth trends. It's worth noting that these metrics are always backwards looking – so investors should be careful to consider any potential future problems, too.
Value investing strategies
There are many tried-and-tested strategies that many investors use when conducting value investing.
The best value stocks usually boast several hallmarks of quality. These include being well-established businesses with a solid history of success through recessionary periods, consistent profitability, relatively stable revenue with limited sales growth or contractions and often regular dividend payments.
Seeking a margin of safety
As intrinsic value is calculated under assumptions and within a given range, value investors require room for error in their calculations set within their own 'margin of safety' based on their personal risk tolerance. This makes you less likely to lose money if the stock doesn’t perform as well as you expect.³
If you consider that a share is worth £10 and buy it for £5, you will make a £5 profit by simply waiting for the share to rise to your perceived value – and it may even make more money if the company grows too. Benjamin Graham only bought stocks he considered to be priced at two-thirds or less of their intrinsic value – a ratio he felt was optimal from a risk-return perspective.
Taking a long-term perspective
It may take many years for a value stock to return to its fair value, and this requires both patience and the ability to believe in your own analysis and strategy.
Many investors get impatient, sell too early or look for faster returns on the market. Importantly, this means that this strategy is only suitable for investors who can readily afford to lock their money away for long periods.
Having a contrarian mindset
Related to the long-term perspective is that value investors need to adopt the contrarian mindset. If a stock is trading for less than its intrinsic value, then it's likely to be out of favour with many other investors who disregard its potential. This can make it even harder to stick to your guns – especially when returns are not guaranteed.
However, value investing involves choosing to buy when everyone else is selling. This sounds easy but becomes psychologically challenging when investing your own money.
Rejecting the efficient market hypothesis
This theory posits that a stock price always considers all public information about a company, and therefore reflects its fair value. Clearly, this is the antithesis of value investing.
Value investors might argue that a share price is underperforming because of extrinsic factors, such as a recession or market panic, or overperforming based on investor excitement that doesn't reflect a company's true value. This is often the case with biotech companies – many promise incredible medical advances, but only a small few deliver.
Pros and cons of value investing
As with all strategies, there are advantages and drawbacks to value investing.
Pros of value investing
- Decent profits – incredible gains are possible with value investing when the market eventually recognises the true value of an asset you bought on the dip
- Low-risks, high-rewards – the risk-to-reward ratio is generally favourable, assuming correct analysis and a large margin of safety
- Compounding returns – value investing benefits hugely from compound returns, especially if you reinvest dividends and any capital gains. Interest on interest is extremely powerful in investing
- Emotionless investing – value investing involves a cool analysis of a company to analyse its prospects and margin of safety, rather than becoming attached to a stock
- Blue chip power – well-established blue chip companies prioritised by value investors are less risky than the small caps
- Ability to invest in an ISA for exceptional compound returns
Cons of value investing
- Research intensive – undervalued shares are hard to identify and require expertise. You also need to understand that not every company you analyse will end up being worth buying shares in
- Ratio analysis flaws – a company's P/E ratio can be determined before or after tax, can only be an estimation, and may differ from another company depending on how earnings are defined or what accounting practices are used. This makes objective comparisons harder than you might expect
- Uncertainty – you have no control over factors such as management changes, a company disaster or competitor behaviours that can change the fundamentals over time
- Patience – of a saint. You often need to hold a position for years to reap the rewards until market sentiment turns positive. Even then, you might hold for a lifetime and still not see a return
- Self-confidence – value investing requires being certain that you have spotted an opportunity that others are shunning. This is highly pressurised, especially if you lack professional knowledge
- Weak diversification – most value investors seek shares in depressed sectors, which means that they are unlikely to be diversified and thus riskier. Further, it can be tempting to rely on past performance of an indicator of future returns, but this is never guaranteed
A value trap is a stock that looks cheap but actually isn't. This is primarily because your analysis of a company's figures is based on historical performance and not future prospects.
Two key value trap situations to be aware of are:
- Stocks in cyclical industries – think construction, mining or oil. These tend to see earnings rise during boom times and collapse during recessions. If shares in these companies are low compared to past earnings, this is often because markets are pricing in weaker future performance.⁴
- Stocks relying on patents – think pharmaceuticals or tech companies. If a drug company relies on one patented drug that is going to come off patent soon, much of its profits can rapidly disappear.
Value traps are not always easy to spot. The key point is that you should consider a forward-thinking analysis before placing a trade.
How to start value investing
- Create your live account in minutes
- Choose fully managed IG Smart Portfolios or share dealing if you want to pick your own value stocks
- If you choose share dealing, conduct further research into your proposed value stock, how to diversify your portfolio and how to manage risk
- If you choose IG Smart Portfolios, we will ask some questions to assess your risk tolerance
- Invest a lump sum or set up a regular instalment to fund your account
New to investing? Open a demo account to build your confidence.
Value investing summed up
- value investing involves buying stocks that appear to be trading for less than their intrinsic value
- value stocks are usually undervalued, have low P/E ratios and high dividend yields
- the risk-to-reward ratio is generally favourable, assuming correct analysis and a large margin of safety
- a key risk is the value trap, where a stock looks undervalued but actually isn't
- you can buy shares with us directly or open a fully managed IG Smart Portfolio