Value investing is one of the most popular investment strategies used on Wall Street today. There’s a good reason this investing strategy is so popular — it works!
Value investing is to the stock market what coupon clipping is to the grocery store. It’s the process of finding stocks that are essentially on sale, trading with lower valuations than their peers.
In the stock market, saving a little now could equate to earning massive returns that outperform the overall market later. The merits of the value investing strategy have been proven time and time again, even by investing greats like Warren Buffett and his mentor, Benjamin Graham.
So, what exactly is value investing and how do you go about being successful at it?
What Is Value Investing?
Value investing is an investment strategy that’s centered around finding quality stocks that are undervalued compared to their peers in the market. Value investors use a wide range of valuation metrics to determine the true value of a stock and look to purchase those that trade below their true value.
The idea is that undervalued stocks will eventually catch up to their peers. So, by investing in high-quality companies that have a discounted market price, the investor will see outsize gains when the stock begins to rise to its intrinsic value.
The most successful value investors have keen fundamental analysis abilities. Moreover, due to its long-term nature, the value investing strategy provides a margin of safety for investors looking to take advantage of a low-risk investment strategy.
Finally, value investing is often considered a contrarian investment strategy. That’s because the value investor believes that the overall market has it wrong, holding a view contrary to those held by the overall investing community.
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Valuation Metrics Used by Successful Value Investors
Value investing is all about finding high-quality stocks that are trading at a discount to other stocks within their industries. But how do you go about gauging the value of a company?
Successful value investors use the following key valuation metrics:
- Price-to-Earnings Ratio (P/E Ratio). The price-to-earnings ratio, or P/E ratio, compares the share price of a stock to the earnings per share produced by the stock over the past year. For example, if a company earned $1 per share over the past year, and the share price is $10, the P/E ratio for that stock would be 10, meaning that at the current rate it would take 10 years of earnings to produce the current market value of the stock.
- Price-to-Book Ratio (P/B Ratio).The price-to-book ratio, or P/B ratio, compares the current price of the stock to the current book value of assets held by the company. This gives the investor an idea of the true value of the company based on its assets. For example, if a company has a total market capitalization — or market value — of $100 million and owns $50 million worth of assets, its price-to-book ratio works out to 2, meaning that investors pay twice the value of the company’s assets when purchasing shares.
- Price-to-Sales Ratio (P/S Ratio). The price-to-sales ratio, or P/S ratio, compares the price of the stock to the revenue generated by the company on an annual basis. For example, if a stock trades with a market cap of $100 million and generates $20 million in revenue on an annual basis, it trades with a P/S ratio of 5.
- Price-to-Cash-Flow Ratio. Finally, the price-to-cash-flow ratio compares the current price of the stock to the cash flow the company generates over the course of a year. For example, if the company generated cash flow of $25 million and trades with a market cap of $100 million, it’s price-to-cash-flow ratio works out to 4.
How to Use These Ratios to Determine if a Stock Is Undervalued
The valuation metrics above tell you a bit about the price of the company you’re looking into, but how do you know if that price is an undervaluation, overvaluation, or sitting right at fair market value? How do these valuation metrics tell you whether a stock is a good investment?
It all has to do with sector averages. For example, if you’re considering an energy stock, you would want to compare the valuation metrics above of the company you’re looking into to the valuation metrics of the energy sector as a whole.
It’s important to compare metrics to the sector you’re investing in because every sector is different. Due to the dramatic growth seen among successful technology stocks and relatively stable growth seen among utility stocks, technology stocks will generally trade with higher valuations than utility stocks. A utility stock with ratios much lower than some stocks in the technology sector may still be overvalued among its peers in the utilities sector.
What to Look For Beyond Valuation Metrics
Value investing is about finding stocks that are on sale. Although paying a good price is obviously important, it’s not the only important factor investors should consider before making an investment.
After all, a stock may look dramatically undervalued, but it also may have earned that low valuation. For example, a stock that produced $1 per share in earnings last year and is trading at $2 per share now has a P/E ratio of only 2, which usually screams undervaluation. However, if the company represented by that stock recently filed for bankruptcy, offloaded its assets, and is nothing more than a shell today, it’s still overvalued and will still lead to losses.
It’s important that you look deep into the companies you invest in, far beyond their current valuation metrics, to ensure you’re buying something of lasting value.
1. Look for a Competitive Advantage
Any good stock investment— be it a value stock, growth stock, or income stock — will have a competitive advantage. For example, Apple’s high-end cameras and cutting edge artificial intelligence, among other key technologies, help keep the company ahead of the curve in the smartphone industry.
Competitive advantages can come in all shapes and sizes. A biotechnology company’s competitive advantage may be a new method of delivery for a medication or a strong scientific advisory board, while an automobile manufacturer’s competitive advantage may be purely cosmetic.
No matter what it is, it’s important that any company you invest in has a competitive advantage that allows it to corner a meaningful percentage of its target market.
2. The Company’s Ability to Protect Its Competitive Advantage
Having a competitive advantage is one thing, protecting it is another. In order to protect intellectual property, companies must have a robust IP portfolio, filled with patents, trademarks, and copyrights that ensure the competition is incapable of selling what the company sells.
The question of whether a competitor will try to mimic a good idea isn’t an “if” question, it’s a “when” question. When a competitor does try to step on your company’s toes, it’s important that the company you’ve invested in has the IP protections and legal clout to defend itself in court.
3. Revenue and Earnings Growth
A stock with a low valuation may seem like a great investment. But what if the valuation is low because the company has had a history of stagnant revenue and earnings? Or worse, what if the company has seen revenue and earnings decline over the past several years?
In these cases, low valuations serve as a warning sign rather than a buying sign.
Before making an investment, look at the past four earnings reports at least. The more history you look into, the better off you are. When digging through the earnings reports, look for the company’s revenue and earnings growth, or lack thereof.
If you find that the company is relatively stagnant or going backward in terms of revenue and earnings, it’s time to go back to the drawing board to find another opportunity, because the stock of a stagnating or shrinking business is likely to produce losses over time.
4. Consistent Innovation
Regardless of the investing strategy you choose to follow, investing in companies that make an effort to stay at the forefront of innovation in their field is an absolute must. There’s no such thing as “too big to fail.” Even the world’s largest companies will fall victim to competition if they don’t continue to innovate and stay ahead of the masses.
Don’t believe me? Just look at BlackBerry.
If you ask your kids about BlackBerry, they’ll probably assume you’re talking about fruit, not about the technology company that largely led the way to the development of the smartphone as you know it today.
At one point, BlackBerry seemed like a great investment. Sales were incredible, profits were compelling, and growth seemed all but guaranteed.
Well, that growth wasn’t guaranteed.
The company failed to stay on the leading edge of innovation in the smartphone industry, ultimately giving up its leading position to Apple. Today, BlackBerry shares trade at a small fraction of what they did in the company’s heyday, and it continues to try and find a way to get back to the good ol’ days.
Even the best-looking company today could be tomorrow’s penny stock. To avoid investing in one of these duds, make sure any company you invest in is actively spending time and money on the development of innovative solutions to problems faced by its customers.
Where to Find Value Stocks
Value stocks can be found in just about any sector. So the real question isn’t “where do you find value stocks?” — it’s “when do you find value stocks?”
Buffett, Graham, and many other value investors would tell you the best time to buy is when pessimism is high.
The stock market tends to move in waves, with the bulls who believe prices will rise taking control in some cases, and the bears who believe share prices will fall taking control in others.
In bull markets, share prices tend to fly out of control, many times reaching incredible overvaluations. It’s at these points that the savvy value investor sells. While there will still be some value stocks on the market, finding strong investment opportunities will be difficult.
In bear markets, share prices fall and widespread pessimism across the stock market leads to widespread undervaluations. This is when the value investor strikes. As Wall Street maintains a “the sky is falling” mentality, discounts will appear across the market, making finding strong value stocks as easy as finding a gas station in the suburbs.
Although you shouldn’t wait for market declines to take place to become active in the stock market, you’ll find it far easier to find undervalued stocks in bear markets than in bull markets.
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1. Small Hidden Gems
In his book “One Up On Wall Street,” Peter Lynch wrote, “Big companies have small moves, small companies have big moves.”
The idea here is simple; investing in companies that are in early stages of business and relatively small compared to their peers gives you the largest opportunity for momentous gains.
Although it’s easy to agree with this concept — and even though undervalued stocks are easier to find in smaller companies than for large, well-established companies — stocks with small market caps also come with increased risk.
So, if you’re going to invest in companies in early stages of business, it’s important to do extensive research into the market opportunity represented by the work the company is doing. Moreover, if you have a relatively low risk tolerance, it’s best to avoid stocks with a small market cap.
2. Popular Value-Focused Index Funds, ETFs, and Mutual Funds
Value investing takes quite a bit of work. Although many think of this type of investment as a more passive one, the most successful proponents of the value investing strategy perform some of the most detailed analyses performed by any investor.
If you’re not experienced in fundamental analysis and just learning the ropes of valuation metrics, it may be best to let the pros choose your investments for you.
No, that doesn’t mean you need to go hire an investment advisor; value-focused mutual funds and exchange-traded funds (ETFs) will do just fine. Some of the most popular value-focused investment-grade funds include:
- Vanguard Value ETF (VTV)
- Blackrock Basic Value Fund (MABAX)
- DFA U.S. Large Cap Value Portfolio (DFLVX)
These funds and others like them include a variety of holdings that are selected for their value investment characteristics. Be aware that these funds carry a small expense ratio — a fee you pay for holding the fund rather than picking and buying individual stocks on your own.
Diversification Is Key to the Success of the Value Investing Strategy
As with any investment strategy, diversification is a key component of value investing. Diversification is a way to protect your portfolio from significant short-term losses should one of your investments take a nosedive.
By maintaining a portfolio of multiple value stocks, index funds, ETFs, and mutual funds, fluctuations — even significant fluctuations — in the price of a single asset in your investment portfolio won’t have a large impact on your overall holdings.
When getting started, beginners should follow the 5% rule. This is a general rule of thumb that suggests a properly diversified investment portfolio has no more than 5% of its value held up in any single investment and no more than 5% of the total portfolio value tied up in a group of high-risk investments.
For example, if you have $10,000 to invest, you should cap single investments at $500. Moreover, you should have no more than $500 invested across all high-risk investments in your portfolio.
Risks of the Value Investing Strategy
Any investment you make is going to come with risk; it’s just part of the dance. If you plan on following the value investing strategy, the most significant risks to consider are:
- Small-Cap Risks. Many value investors focus solely on small-cap stocks to find hidden value. These stocks are known for heavy volatility, making timing your entrances and exits difficult. Moreover, most stocks in the small-cap category haven’t proven their business model and don’t generate profits. As such, if you’re going to look toward small caps for strong value plays, it’s important to do your research to understand what you’re getting into.
- Valuations May Be Low for a Reason. Value investing is all about finding high-quality stocks with low valuations. However, stocks may be carrying low valuations for many reasons. Some, like bankruptcy filings, are easy to find. Others, like share agreements that leach off the company’s revenue, can be more difficult to pin down.
- Lack of Liquidity. Often, low valuations are the result of a lack of investor awareness surrounding the stock. If investors don’t know the stock exists, there’s not much demand to buy it. This leads to a new issue: If nobody wants to buy the stock, what do you do when you want to sell it? When buying lesser-known value stocks, you may be left holding onto your positions longer than you intended simply because there’s nobody interested in buying your shares.
Some of the Most Widely Recognized Investors Are Value Investors
Value investing is no fad. The strategy has been used for decades by some of the world’s most successful and widely recognized investors, including Warren Buffett, Charlie Munger, and Peter Lynch.
The economist Benjamin Graham laid the groundwork for value investing as we know it, becoming one of the first investors to focus on valuation metrics as buying and selling signals. He was also Warren Buffett’s personal mentor.
As the father of value investing, Graham is one of the most highly regarded investors that has ever walked the face of the earth. He is also the author of the book, “The Intelligent Investor,” a must-read for beginner and expert investors alike.
One of the most important quotes from Benjamin Graham surrounding value investing is: “Buy when most people, including experts, are pessimistic, and sell when they are actively optimistic.”
Value investing is an exciting way to go about building wealth in the stock market. Not only will you be investing in your future, you’ll be bargain hunting. Bargain hunting is an enjoyable process. It’s why you’re willing to clip coupons or search online for the best deal on the products you’re interested in.
In many cases, coupon cutting and online searching costs more in time than the discount is worth, but for many it’s as much about the thrill of the chase as it is about catching the prey.
Bargain hunting in the stock market brings the thrill of the chase to a whole new level. Moreover, making the right moves in accordance with a solid value investing strategy will result in market-leading returns.
However, it’s also important to do your research. Making the wrong moves in search of a discount could result in significant losses.