Value investing, as the name suggests, consists of finding investments that are good value for money. A value investor actively seeks out stocks, bonds or other investments that he or she believes have been undervalued in the market.
The price of an investment should be a reflection on its future returns as well as the risk that those returns might not be achieved. Value investing seeks to identify investments below their fair value.
There are many reasons why a stock might be undervalued. Often, when a public company reports poor profits, investors react emotionally and sell their stake in the company. This causes their stock price to take a hit. That dip in profitability might not be any reflection on the companies future potential. This means purchasing stock at the now lower share price increases the value you’re getting.
For example, if the company had a share price of $100 last week and $50 dollars this week, this week you can get twice as many shares for the same amount of money. Assuming that you put the same value on the company this week and last — you’re now getting more value for money.
You could describe a form of value investing as buying low and selling high. In theory that sounds great. However, it’s much easier said than done. Valuations are subjective and tricky to estimate. Value investors typically look at past performance and forecasts to determine how much a company is worth now and how much it will be worth in the future. They make trades based on these forecasts. If their predictions are not right, they stand to lose a lot.
The concept of value investing was developed by Benjamin Graham in the 1900s. Soon after coming up with the principle of value investing he authored a book with David Dodd called “Security Analysis”. In the book, Graham and Dodd describe the various forms of value investing.
Value investing isn't (necessarily) about being a good person—like someone who recycles and buys organic and uses bamboo toothbrushes). That's ESG investing. Value investing isn't about values, but value.
How value investing differs from speculation
Value investing is a form of speculation. It differs from hunches as investors typically use systematic strategies to invest in a variety of value stocks. Instead of chasing after “the next big thing” that will maybe grow enormously in the future, they’re looking for investments that have shown themselves to be sold under value in the current market. There are many reasons an investment, such as a stock, could be undervalued. For example, a scandal that may have temporarily tanked the stock. The hope here is that other investors will also recognize the stock’s intrinsic value over time and help change the stock’s course.
Value investors believe in playing the long game. By investing in a stock that they believe is undervalued, value investors are subscribing to the school of thought that holds the course of a stock will ultimately line up with its intrinsic value or strength. This belief isn't the product of blind faith but from a careful calibration of a stock’s performance and nature.
Lots of academic research has shown that a “value premium”, or a return above what you would expect from investing in the general market, persists across time and asset classes. Some value investors use systematic strategies to buy baskets of stocks with attractive value characteristics with the expectation that, over time, this basket will outperform.
Value investing strategy
How do investors determine the value of a company? In investing terms this is known as “intrinsic value” and it considers a number of factors. Value investors usually look at stocks with a lower-than-average price-to-earnings ratio or its PEG (price/earnings-to-growth) ratio in order to determine the relative trade-off between the price of a stock, the earnings generated per share (EPS), and the company's expected growth.
Another important aspect of value investing is a stock’s margin of safety, which is the difference between a stock’s intrinsic value and its current market price. A good margin of safety would be pretty high since you’d look at a company’s or stock’s past performances and then buy at a big enough discount that it would allow a buffer in the event of some future decline in the stock.
Historically, value investing has provided a premium over investing in the broad stock market because investors who focus on value investing tend to try to avoid the type of herd mentality that can be a byproduct of active trading.
The long-term nature of value investing means that it can take years to see any payoff, which is why experts often recommend investing in a diversified set of value stocks.
Examples of value investing
Perhaps the most famous value investor is Warren Buffett. (You may have heard of him.) He’s primarily known for being very, very...rich. He’s also known for how he became so rich. Buffett’s approach to value investing has become a quasi-bible for value investors.
Buffett is known for condensing financial concepts into digestible analogies, like his explanation for the importance of a margin of safety in value investing demonstrates. He compares it to driving across a bridge:
“You have to have the knowledge to enable you to make a very general estimate about the value of the underlying business. But you do not cut it close...You don’t try to buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing.”
Alternatives to value investing
Value investing might not be a good option unless you're able to put some serious time and research into building your own portfolio and trading yourself. And even at that — it's risky. For every one amazing value investor, like Warren Buffett, there are hundreds if not thousands of others that don't fair well. Those folks tend to make the news less often.
Value investors normally invest in a few companies they perceive to be undervalued rather than invest in a whole platter of stocks, bonds, and real estate. This means if those few investments don't do well — you've lost your shirt.
An alternative to value investing is spreading your money across a multitude of stocks, bonds and real estate in an attempt to track the market. Although the market will have booms and busts, studies show that historically the value of the S&P 500 has increased over time. Does this mean this trend will continue — absolutely not? But if you don't need your money in the short term and can afford to suffer the ups and downs of the market, this is an alternative to value investing.
You can track the market by investing in index exchange-traded funds. These funds invest your money across stocks, bonds and real estate in order to mirror exactly how the market performs. The major advantage — diversification. This minimizes your risks of having a loss — should one part of your portfolio do poorly, you haven't lost everything.
