Value investing is one of the most widely used approaches for trying to generate favourable returns in the stock market. Learn how to implement a value investing strategy, how to identify value stock investments, and some of the risks attached to value investing.
Value investing is one of the most well-established and effective investment approaches. It involves using key metrics to identify undervalued stocks that have the potential to see a price increase at some point in the future.
There is a wealth of readily available information and data for investors and analysts to take advantage of, and by adhering to a few essential guidelines, you can construct your own value-based portfolio.
The stock investor is neither right or wrong because others agreed or disagreed with him; he is right because his facts and analysis are right.
Benjamin Graham
What is value investing?
Value investing involves conducting fundamental analysis and studying economic cycles to determine whether the underlying prospects of a firm are currently being misinterpreted by the market. This misinterpretation can result in the price of a stock being considered “cheap” in comparison to the company’s intrinsic value or a stock market benchmark.
Some of the world’s best investors follow a value investing strategy, such as Warren Buffett and Benjamin Graham, the latter of which is widely considered the “father of value investing.”
Applying a value investing strategy
Value investing tends to favour investors with a buy-and-hold approach, as it can take time for the anomalies behind a stock’s mispricing to work themselves out.
That said, once these factors play out, the resulting renewed upward momentum in a stock price can potentially be long-lasting, making it an ideal strategy for those with a longer investment time horizon.
How to identify value stock investments
Many of the techniques used to establish a stock’s “true” value rely on fundamental analysis. Firms regularly release financial reports, such as balance sheets and income statements that outline crucial figures including revenue, profit margins and capital investment levels.
To help investors compare stocks and sectors, a lot of this base-level data is converted into multipliers and ratios. Though they may initially seem complex, these ratios can help to simplify the evaluation process by comparing different elements of a firm’s performance and condensing them into a single number, such as the P/E ratio, which measures a firm’s share price against its earnings. The lower the P/E ratio, the greater the likelihood that a firm is undervalued.
Tip: In the US stock market, earnings season coincides with firms releasing reports at the end of each fiscal quarter.
Value vs growth investing
Value vs growth investing has long been a heavily debated subject among investors. Value investing can involve the evaluation of a firm’s new and upcoming projects, but its primary focus lies in assessing a company’s current cash flows and determining if its share price should currently be higher. Conversely, investors that buy growth stocks are more concerned about a company’s future prospects.
Both value and growth investors aim to buy low and sell high, but the underlying reasons for the price movements will differ.
What is a deep value investment strategy?
Investors that seek the most undervalued stocks are often following a deep value investment strategy. However, the extent to which a stock price can trade below a company’s intrinsic value varies.
The risk-return ratio is higher for those interested in deep value investing, given that some of the stocks they consider may be facing difficulties, hence their extreme undervaluation.
Risks of value investing
Because of the natural cycles of the stock market, sometimes a large percentage of stocks go up or down in price at the same time. No matter how thorough your analysis is, if you buy a value stock at the top of the market, you are exposing yourself to market risk.
In addition, some risks are stock specific. It is easy to miss indicators that suggest that the stock you are considering is not actually undervalued. Even if your analysis is accurate, any potential price increase may be contingent on a catalyst that sparks renewed interest in the stock. This can take time to materialise, and undervalued stocks can remain undervalued for extended periods of time.
Tip: Value investing strategies are most effective when there are no time restrictions on selling a stock.
Hedging value investment strategies
Value investing is an intuitive prospect that tends to suit investors with a long-term view. However, relying solely on value stocks can have its drawbacks. Building a diversified portfolio in terms of strategy and asset type can help to smooth out returns and make it easier to maintain your positions when the stock market turns bearish.
There are also other ways to hedge against market risk:
- Options: Options can act as an insurance policy. They give the holder the right, but not the obligation, to buy or sell an underlying instrument at a future date. It is possible to buy options in single stocks or stock indices, with the latter offering additional protection against a wider market correction.
- VIX index: The VIX Index is a tradable instrument that measures price volatility in the financial markets. Volatility tends to increase during moments of market uncertainty, such as stock market crashes, so investing in the VIX can offer protection against a sell-off in all stocks, including value-based ones.
- Defensive stocks: Historical data demonstrates that certain stocks tend to retain their value better than others during market downturns. Examples of defensive stocks include the food manufacturer Kraft Heinz and healthcare giant Johnson & Johnson. Whatever the prevailing economic conditions, demand for food and pharmaceuticals will usually remain stable.
Final thoughts
The underlying principles of value investing are straightforward, although mastering the strategy will require some time and effort. Thankfully, most good brokers will offer free research and analysis, along with tools that consolidate the essential ratios and multipliers. Value investing can also involve waiting for the rest of the market to realise the mispricing and for the price to readjust, hence the following remark from famous economist John Maynard Keynes:
Markets can remain irrational longer than you can remain solvent.
John Maynard Keynes
Visit the eToro Academy to learn more about growth and value investing.
Quiz
FAQs
- What are the biggest downsides of value investing?
-
Even if you correctly identify an undervalued stock, there are no guarantees regarding the timing or occurrence of the price correction. The opportunity cost in this scenario is the potential missed investment opportunities that you forego because your capital is tied up in a value investment strategy.
- What are the best metrics to use when carrying out value analysis?
-
Popular metrics include the P/E ratio, P/B ratio and dividend yield. A key aspect of successful value investing lies in knowing which analysis tool to apply to a particular stock or sector.
- What if my analysis points to a stock being overvalued?
-
It is possible to make returns on falling share prices by using CFDs to sell-short. Selling short is generally considered riskier than traditional buy-and-hold investing, as potential losses are unlimited. Despite the risks, shorting overvalued stocks offers an additional method of hedging against market risk. Hedge funds are renowned for employing long-short strategies, enabling them to generate returns while maintaining a market-neutral position.
This information is for educational purposes only and should not be taken as investment advice, personal recommendation, or an offer of, or solicitation to, buy or sell any financial instruments.
This material has been prepared without regard to any particular investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Not all of the financial instruments and services referred to are offered by eToro and any references to past performance of a financial instrument, index, or a packaged investment product are not, and should not be taken as, a reliable indicator of future results.
eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this guide. Make sure you understand the risks involved in trading before committing any capital. Never risk more than you are prepared to lose.