Many stock market strategies seek to capitalize on investing trends. They focus on stocks that are popular at the moment, for example, those that are leading the current market trend. While that strategy often leads to superior short term results, it can also lead to a portfolio filled with the hardest hit stocks in a market slide. Is there an alternative strategy? Yes—it’s called value investing, and it’s just what the name implies. And with the stock market being as volatile as it is right now, this may be the very best time to take a close look at this strategy.
The basics of value investing
Investopedia defines value investing as “The strategy of selecting stocks that trade for less than their intrinsic values.” Intrinsic value is the primary determination and it can be very subjective in nature. There are various ways the value investor determines if a stock is undervalued:
- A stock has a higher dividend payout than what is typical for its industry
- A lower price/earnings ratio than is typical for its industry
- The collective market value of the company’s stock is lower than its “book value” (the company’s total assets, less liabilities and intangible assets)
Any of these conditions may have developed due to an otherwise strong company having its stock decline as part of an industry-wide sell-off, a run of bad news that’s hammered the stock price but seems to be subsiding, or simply because other stocks in the sector are drawing more attention. It’s also important to realize that value investing isn’t simply a play on falling stock prices. A large drop in the price of a stock could signal problems with the company’s fundamentals, which might eliminate the stock from consideration.
The advantages of value investing
Value investing, for the most part, ignores current trends in favor of company fundamentals, and has many advantages over other forms of stock market investing, including:
- Value investing is like buying stocks at a discount, and those are the stocks that have the greatest potential to outperform the market.
- It stacks the long-term in the investors favor.
- Value investing is low maintenance—there is no need to monitor stock performance day-to-day.
- They’re less affected by short term drops in the stock market than more trendy stocks.
- You won’t become a trader with value stocks, and therefore won’t be faced with paying the fees that traders typically pay.
- There’s no need to adjust your stock strategy with every shift in the stock market.
- Because of all of the above, value stocks make for restful nights—a lot of them.
Because value investing is so focused on the long-term, it’s perfectly suited for retirement investing.
What you’ll give up if you invest this way
Probably the biggest “sacrifice” involving value investing is that you will probably sit out a few big stock market runs! Because you aren’t invested in the current trend, you’ll mostly watch as they (the trends) come and go. Value investing is also the practice of “patient capital”—the willingness to buy right and then wait for your picks to rise in value. That’s a process that can take years! In today’s world of web surfing, 200 cable TV channels and drive through service, value investing can be kind of, well…boring!
This is especially true if you’re a results kind of person, and even more so if you like high adventure and a lot of it. Most days—even some years—not much happens with value investing. Value investing is long-term investing, which is to say that if you’re looking for action in your investment portfolio you won’t find it with this strategy.
Another downside is that it generally requires more research and analysis than you’ll find with short term strategies. You’re looking at the available information on a company from the usual sources and making a determination that the company’s stock is in fact under-valued based on additional research and analysis—yours, generally. That will take skill, experience and some gut instinct. Value investing, therefore, is not for the novice!
Still another factor is the number of stocks available. Computers have made it easier for investors to track literally thousands of stocks, which is to say that pricing has become more efficient. Because of this, the pool of stocks that might qualify as value related is relatively small. Generally, as soon after a stock is determined to be under-valued, it gets scooped up by large investors, like mutual funds and pensions, and might no longer be under-valued.
Is value investing worth it?
Value investing is a time honored investment strategy and is the hallmark of many successful long-term investors including Warren Buffet. The results speak for themselves. The value investor makes solid stock picks based on the strength of the underlying companies and is less subject to the ups and downs of the general stock market. Because many value stocks have already come through periods of decline, they tend to fall less than other stocks that may have ridden a bull market to the top. And while value stocks may not always be the high flyers in the latest bull market run, when they do finally take off, you may get greater gains from having bought when no one else was paying attention. “Buy on bad news, sell on good news” is at the heart of value investing. Is it worth it? Most definitely!
Photo by Jacob Ehnmark via Flickr