Among the various investment strategies, value investing has proven to be one of the most widely respected, successful, and profitable investment methods that have brought wealth and fortune to investors who have followed value investing principles effectively. Warren Buffett, chairman of Berkshire Hathaway and one of the world’s most famous investors, has always been a strong proponent of value investing. He contributes his success to this investment philosophy.
This article discusses what value investing is, how it works, its history, its fundamental principles, what to look out for, and its relevancy in today’s volatile market. This guide will help you understand how you can invest in value stocks, profit from this proven strategy, and build long-term wealth so you can live the life of your dreams during retirement.
What Is Value Investing and How Does It Work?
Much like buying consumer goods at discounts, value investing is a strategy where investors focus on buying stocks, bonds, and other types of assets at a price that is perceived as lower than their intrinsic value or book value.
Value Investors actively look for stocks they believe the stock market is underestimating and are therefore lower priced than their true value warrants. Value investing is based on the premise that acquiring an undervalued asset offers an opportunity to profit later. When the asset’s market price has reached its intrinsic value or surpassed that value, selling the asset will realize significant gains.
For example, a value investor is looking to buy shares that were selling for $110 a year ago but are now selling for $70. After careful analysis of the company’s financials and business fundamentals, the value investor believes that this company’s stock price will increase again to at least $110 when the economy picks up again. The idea is that eventually, the market will recognize the true value of this stock again, and when it does, this company’s share prices will rise again, and the value investor will reap the benefits.
Value investing sounds pretty straightforward. However, there are some challenges to conquer first. In practice, it is not easy to find undervalued stocks. If it is evident that a stock is truly undervalued, many investors will buy it, which will result in a price increase, and the bargain will not exist for too long.
One of the keys to being a successful value investor is that you will have to find value stocks that are bargains and “diamonds in the rough” simultaneously. These value stocks are undervalued, very few other people know about them, and these stocks must have a significant opportunity to appreciate. To find them will require in-depth company research and fundamental analysis of relevant investment metrics and possible intangible assets. This can be time-consuming and complicated.
Another challenge is that it might take a long time before the acquired asset’s price or market value reaches its intrinsic value level. It is even possible that it will never reach that level, which can result in potential losses.
Value investing involves investing in quality companies that the investor thinks are undervalued. It is all about doing detective work to find assets on sale that a few people know about. Investors get rewarded for buying assets at discounted prices and holding on to them until the prices reach or surpass their true value. It often is a buy-and-hold and long-term strategy.
There are plenty of mutual funds and exchange-traded funds (ETFs) that focus on value stocks available to investors who want to invest in value stocks but do not have the time or interest in all the research involved in finding them. By buying these mutual funds and ETFs, someone else has already done most of the work for you. Another less time-consuming way to participate in value investing is to follow the moves of well-known value investors such as Warren Buffett and copy their behavior.
History of Value Investing
The concept of value investing was born when Benjamin Graham and his co-author David Dodd published a classic investment book called “Security Analysis” in 1934. The book describes that investors should refrain from anticipating price movements, as was done in the past. Instead, they should try to estimate the true value or the intrinsic value of an asset. In time, the intrinsic value and market value will converge, and profits can then be realized. This investment strategy later became known as value investing. The great depression of 1929-1930 was an inspiration for developing this value investing philosophy.
Ben Graham became known as the father of value investing after publishing his second book “The Intelligent Investor” in 1949. This book brought value investing to individual investors and is still widely acclaimed today. Ben Graham was a professor at Columbia University Business School. Warren Buffett, the most successful practitioner of the value investing strategy, was a student of Graham and later became an associate in Graham’s investment company. Warren Buffett has since further popularized the value concept among investors.
Buffett learned how to find undervalued companies with good cash flows and solid financials. An investment group led by Buffett took complete control of Berkshire Hathaway in 1965. With Charlie Munger’s help as Vice Chairman, Buffett made Berkshire Hathaway one of the world’s largest multinational conglomerate holding companies. Berkshire Hathaway hit a record $549 billion market cap at the close of trading on November 24th, 2020. It holds more than $100 billion in Apple stock and has billion-dollar stakes in value stocks such as American Express, Bank of America, and Coca-Cola.
According to Berkshire Hathaway’s “2019 Annual Letter to Shareholders,” from 1965 to 2019, the annual performance of Berkshire Hathaway’s stock was 20.3%, which was more than twice that of the S&P 500’s annual performance of 10% over that period. It has made Buffett one of the richest and most famous value investors in the world. At 90 years old, he still is an active chairman and CEO of one of the most successful companies ever.
Key Principles of Value Investing
Value investing is a strategy that can definitely outperform the market if done correctly. However, there are some important principles one should keep in mind to become a successful value investor.
Focus on intrinsic value
Value investing is based on the concept that a stock’s price will eventually match its intrinsic value. Investors look for stocks that can be purchased at discounts to their inherent value. They use different methods to calculate and estimate the intrinsic value of a company. Investors use qualitative and quantitative factors, such as industry performance, assets, earnings, company management, brand, competitive advantage, and target market to determine a security’s intrinsic value. Further explanation of how to calculate a company’s intrinsic value will be discussed later in this article.
One of the easiest ways to find a company’s intrinsic value is to identify or calculate its price-to-earnings ratio. If you find a company with a P/E ratio significantly lower than its competitors, it might be a value stock if the company’s fundamentals are solid and its future looks promising.
Markets are inefficient, resulting in undervalued stocks
Value investors believe that markets are inefficient. In an efficient market, stock prices will always reflect their true inherent value. Instead, value investors believe that stocks can be under or overpriced for various reasons. The undervalue could be due to company-specific, or industry or sector-specific socio-economic reasons, an overall market slowdown, or an unexpected event.
A stock might be undervalued after a company does not meet its earnings expectations several times in a row, and the market views its long-term potential negatively. Another company-specific reason why a stock might be undervalued can be a pending lawsuit against the company.
Sometimes several stocks in a particular sector can be undervalued because promising new technology is not meeting expectations. A general market downturn can also result in many stocks becoming undervalued and can create great value-investing opportunities.
Stocks might also become underpriced because an unexpected event might cause a market crash when investors start panic-selling. An example of this is the 2020 stock market crash, also known as the Coronavirus Crash. The Covid-19 pandemic resulted in a massive sell-off and the biggest market downturn since the Wall Street Crash of 1929.
As times are still uncertain, nobody knows what direction the economy will take in the near future. As of November 25th, 2020, many stocks and indexes have recovered and are at all-time highs right now. Some value investors have already bought stocks that they believe are significantly undervalued, while other investors believe that investing in growth stocks is a better strategy at this time.
Use of margin of safety
The margin of safety is defined as the difference between the stock’s current market price and its intrinsic value. It is the core principle of value investing. Value investors look for stocks with a considerable safety margin to be successful. This principle is based on the concept that buying at bargain values gives you a better chance to earn a profit when you sell. In other words, the margin of safety is the level of risk an investor can live with.
The margin of safety also reduces your chances of significant losses if the stock price does not meet expectations. Because the stock price is already below its inherent value, it is also less likely to take a big dive during periods of market volatility or when the company’s sector takes a hit.
What is the right margin of safety? That depends. Value investors set their own margins of safety based on their personal risk tolerance. Benjamin Graham only bought stocks when they were priced at two-thirds or less of their true value. Warren Buffett likes a margin of safety of over 30%, meaning the stock price can drop by 30%, and he will still not lose money. Often the margin of safety for stocks he invests in is larger than 50%. Warren Buffett and Seth Klarman popularized the principle of the margin of safety, and it is now one of the core principles of the value investing strategy.
It is not always easy to find companies with a good margin of safety, but by conducting in-depth analysis and using the right metrics, value stocks can be found.
Value investing takes patience and is certainly not a short-term strategy. It is a buy-and-hold strategy, and it is based on the long-term growth potential of the undervalued company. It often takes many years to see its share price rising to match the company’s real worth.
One of the hardest things about value investing is holding on to the investment through market volatility, and even when it looks like the price might soon drop. Investors who have the patience and can afford to wait a long time usually make the biggest profit. Holding on to value stocks for at least 10 to 20 years is often expected.
In the long run, the market is efficient, and the stock price will converge with the company’s true value. When that happens, the stocks you bought at a discount will have appreciated faster than the overall market.
This principle refers to finding companies with some long-term competitive advantage that is difficult to copy. This helps protect the company’s profitability and market share over time. Common economic moats include technology, cost benefits, brand identity, patents, and high switching costs.
Requires a contrarian mindset
Value investing is not the right option for herd followers. Successful value investing means you have to find undervalued stocks before other investors find them. Otherwise, the margin of safety erodes quickly. This also means you do not follow Wallstreet’s analyst and expert views and recommendations but look at places in the market that most other investors ignore.
Basically, a contrarian investor is someone who trades against prevailing market recommendations and sentiments. When the market sells, the contrarian investor buys and vice versa. Value investors often buy in a bear market and sell in a bull market. Going against experts’ opinions is not an easy thing to do, and if you are wrong about a stock, you will pay the price. Luckily, if the stock does not go up in price, the margin of safety provides some cushion against major losses.
Value buyers do not buy trendy stocks. Instead, they invest in companies that are not that well-known but have solid fundamentals and finances. Value investors also invest in well-established, well-known blue-chip companies that have a good outlook, but for some reason, their stock price has dropped well below their intrinsic value. Companies that pay dividends are also popular with value investors.
In-depth fundamental and financial analysis is key
You must take the time to analyze the company you are investing in and understand its financial structure, future cashflows, competitors, management, and future potential. Different value investors will use different fundamental and financial analysis methods to determine if a stock is undervalued and by how much.
Some investors will primarily look at a company’s future potential and future cash flow. In contrast, others will primarily look at a company’s history, particularly its financial statements such as its balance sheet, income statement, and cash flow statement, and use ratio analysis to value a company. Always make sure you have the most updated information and that your calculations are accurate. You should pay attention to the footnotes, extraordinary items and exceptions, and write-offs in financial statements.
The more research you do, the better. Please note that some of the research results are subjective. This can result in different investors analyzing the same data set but coming up with different company valuations.
Outperform the market
It should be a value investor’s goal to outperform the market. If you cannot beat the market, you should invest in mutual funds or ETFs that follow a market index. That way, you can save a lot of time and effort and leave the hard work to professional fund managers. It is their job to pick the right stocks to build a diversified portfolio that will do better than the market.
Metrics to Calculate Intrinsic Value
Intrinsic value is a central concept for value investing, and it is not easy to calculate. This term refers to the true value of a company, and there is no definite method to determine it. If you ask ten experts to calculate a stock’s intrinsic value, you will likely get ten different responses. The key is to develop your own effective way to calculate the intrinsic value of a company or a stock.
Value investing involves using different methods and valuation metrics to determine the intrinsic value of a stock. Intrinsic value is often a range and not a precise number. It involves analyzing a company’s financial performance, future cash flow, discounted cash flow, revenue, profit, and earnings. Many of the metrics used for stock valuation can be found in a company’s annual and quarterly reports and its financial statements, such as its balance sheet, income statement, and cash flow statements.
Here are some of the metrics that help calculate the intrinsic value of a stock.
Price-To-Earnings ratio – The P/E ratio shows a company’s market value relative to its profitability. It is calculated by dividing a company’s current stock price by its earnings per share (EPS). It shows the money investors are willing to pay for $1 of a company’s earnings. A price-to-earnings ratio of 10 suggests that investors have to pay $10 for $1 in current earnings.
When comparing P/E ratios of different companies, it is important to compare similar companies within the same industry or sector because P/E ratios tend to vary from industry to industry and sector to sector. For example, health care companies may sell at an average P/E ratio of 34, while some other sectors only trade at an average P/E ratio of 12.
A lower P/E ratio than other companies in that same sector often indicates that the stock may be undervalued, which is suitable for value investors who are always looking for a bargain. On the flip side, it could also mean that investors are factoring in warning signs that indicate lower earnings or other problems in the future.
PEG ratio – also called the Price/Earnings to Growth ratio, is another stock valuation metric often used in value investing. Many investors prefer it over the P/E ratio as a valuation metric because the P/E ratio does not consider a company’s future earnings growth, and the PEG ratio does. It can be calculated by taking a company’s P/E ratio and dividing it by its earnings growth rate for a specified period.
The PEG shows investors whether a stock’s price is overvalued or undervalued. It analyzes both today’s earnings and the expected growth rate for the company. Typically, a PEG ratio of less than 1 indicates an undervalued stock.
Price-to-Book Value – The P/B ratio shows the company’s market value relative to the value of its net assets per share. The book value is the value of a company’s equipment, buildings, and the rest of its business assets. When comparing a company’s P/B ratio with other P/B ratios of other companies in the same industry, a lower P/B value can indicate that the company is undervalued, as long as its fundamentals are solid.
Debt to EBITDA ratio – High values of the Debt-to-Earnings Before Interest, Taxation, Depreciation, and Amortization ratio indicate a highly indebted company and might therefore be undervalued by the market. However, too high a debt can be a cause for concern. That is why it is important to include a debt metric in the calculation of the intrinsic value. The Debt-to-EBITDA ratio is one of the easiest ratios to calculate.
When determining what a high or a low ratio is, it is important to look at the industry average as they vary greatly by industry. In some industries, a debt/EBITDA ratio of 10 is considered normal, while in other industries, a ratio of 3 to 4 is more appropriate.
Cash Flow Multiple / EBITDA Multiple – Another good way to determine if a company is undervalued is by looking at its EBITDA multiple, which can be calculated using its Enterprise Value (Market capitalization + Total Debt – Cash) and divide it by the EBITDA.
When the ratio’s value is significantly lower than the industry average, it signals that the company might be undervalued. When it is higher than the industry average, it signals that it might be overvalued.
Watch Out for Value Traps
Investors should note that not all stocks that appear to be value stocks are good investments. One of the most difficult aspects of value investing is determining whether the stock you are considering buying is a real value investment or a value trap.
An actual value stock has a low price because of temporary factors. Its price is a bargain because it sells below its intrinsic value. However, the price of a value trap is low because of long-term or more permanent factors. This usually happens when something has changed or will change, which negatively affects the company’s earnings or cash flow. Generally, a company that has been trading at low earnings multiples or book value for an extended period of time has little promise and can be a sign of a value trap.
Value traps are often previously successful companies that do not have much to offer in the future. These companies may not have solid business plans and do not show reasonable growth in the future because they may have lost their sustainable competitive advantage. These companies may be cutting dividends, publishing misleading financial statements, or their debt keeps rising.
Investors can avoid value traps by thorough research and fundamental analysis of the stock. Careful evaluation is recommended before investing in any company that appears cheap based on conventional valuation metrics.
If investors do their homework, they will find the value traps. Value investing is all about finding the best opportunities among the options available. Paying attention to parameters like cash flow, debt, past and present performance, and company growth will prevent you from making bad investments.
Value Stocks vs. Growth Stocks
Stocks can be classified into growth stocks and value stocks.
Growth stocks grow faster than the average stocks in the market and show a high-growth potential in the near future. Growth companies usually reinvest all earnings they accrue to accelerate their growth. These companies offer consistent earnings growth records in comparison to the market or industry. They are generally perceived to be less established companies with high-growth potential regardless of the economy. They can also be high-quality stocks of established companies with excellent prospects.
On the other hand, value stocks are currently undervalued compared to their intrinsic value or actual worth. Value companies are usually established companies with sound financials and fundamentals, but for some temporary reason, they are presently believed to be less lucrative investment opportunities by most investors.
Some of the most notable differences between value stocks and growth stocks include:
Risk/volatility – Growth stocks are riskier as they are highly volatile. On the other hand, value stocks are less volatile and less risky.
Return Potential – Growth investing has a higher upside potential based on the idea that these companies continue making innovations. On the other hand, value investing has lower upside potential in the short term.
Market Perception – Investors perceive growth stocks to be associated with high-growth companies with outstanding prospects. Growth stocks exhibit high price-to-book value ratios and price-to-earnings ratios. Value stocks are considered less valuable by participants because of the unfavorable temporary conditions. Value stocks usually have relatively low P/B and P/E ratios.
Market – Value stocks tend to do well in bear markets whereas growth stocks do well in bull markets.
Dividend Yield – Growth stocks usually offer no or meager dividends, while value stocks offer relatively high dividends.
Value Investing or Growth Investing; Which Is Better?
Over the past 10 years, growth stocks have outperformed value stocks. This, however, does not suggest that growth investing is better than value investing. Historically, value investing has outperformed investing in growth stocks over the long term.
Currently, growth companies such as Tesla, Facebook, and Amazon are outperforming value companies. Even older, less tech-savvy companies, such as Home Depot, can be considered growth investments today.
Current macro-economic trends such as low-interest rates favor growth investing while at the same time, Covid-19 has helped tech companies. Stock prices such as Amazon, Home Depot, and Zoom have skyrocketed due to increased online shopping and remote learning and working. While these factors may favor growth investing in the near term, with Covid vaccines being administered, this trend most likely will not last forever and eventually end. The big question is when it will end, and when will value investing take over again?
History shows that neither the value investment strategy nor the growth investment strategy has outlasted the other indefinitely. Please be aware that over shorter periods, the performance of growth and value stocks will also depend on the business cycle stage that the market happens to be in. Generally, growth stocks perform better in a bull market, whereas value stocks perform better in a bear market.
Ultimately, the decision to invest in growth versus value stocks is a decision an individual investor has to make based on their investment goals, risk tolerance, and time horizon.
Value investing is a powerful investment method that works for those who are patient and are willing to put in the time and effort to do the in-depth research and fundamental analysis required for finding stocks with values that are significantly below their intrinsic values. Value investing focuses on earning profits in the long run and rewards those who stick around and wait for returns.
Value investing is not the only sound approach an investor can follow. When investing for the long term, many investors combine growth and value stocks or funds for the potential of high returns with less risk. This combined approach allows them to increase their wealth throughout economic cycles in which the market situations favor either growth or value stocks, smoothing any returns over time.
Another investing principle to keep in mind is to make sure your portfolio is diversified. Diversification minimizes your risks should one part of your portfolio do poorly.