Simply put, value investing is an investment strategy in which investors look to buy stocks that are on sale. However, that is an oversimplification. Value investors are looking for that are trading below their intrinsic value.
This is an important concept to understand. Intrinsic value is what the company is really worth, which can be very different from what the stock price shows.
And while that price discovery may take awhile, value investors know that over time, the market is highly efficient. Good stocks will reach their true value at some point.
In this article we’ll help explain value investing and offer tips on how to profit from this strategy.
How to Identify Value Stocks
Value stocks share many (but not necessarily all) of these characteristics:
- They are companies that are in a mature phase of its business cycle
- They offer steady growth
- They have reliable revenues and earnings
- They may pay a dividend
How Does Value Investing Differ From Growth Investing?
Both investing strategies require levels of discipline and commitment. However value investors are looking exclusively at stocks that are trading below their intrinsic value. Overvalued stocks are not a consideration. Growth investors on the other hand are content to “ride the wave” if they find a stock that meets their growth objectives.
Tesla (NASDAQ:TSLA) stock is a good illustration of the difference between growth investing and value investing. In 2020, TSLA stock was being driven “to the moon” as the saying goes. But the rally forward was largely being driven by investor sentiment. Fundamentally there was no reason to believe that Tesla stock was worth what it was.
Here are some strategies that can help make you a better value investor:
Don’t Confuse Price With Value
Price is what you pay for something; value is what it’s worth. This is important for value investors to remember because frequently there are good reasons that a stock is heavily discounted.
The "meme stock” trade of 2021 is an illustration of buying on price alone. However, in many cases, an inexpensive stock is inexpensive for a reason. Value investors will dig deep into a company’s financials to see if the low stock price is an opportunity or merely a reflection of the company’s intrinsic value.
Warren Buffett is considered one of the legendary value investors and is attributed with saying, “It's far better to buy a wonderful company at a fair price, than a fair company at a wonderful price.”
Rely on Fundamental Analysis
Every investor needs to know how to use fundamental analysis to perform due diligence. Successful value investors will look at fundamental analysis metrics like price-to-earnings or price-to-book ratios. However, the difference between a value investor and a growth investor is that a value investor will walk away from a stock that is showing itself to be trading at or above its intrinsic value. That would not meet a value investor’s philosophy to buy stocks that are on sale.
Know What You Own
In the context of value investing, know what you own means understanding what sector a stock occupies and how that may affect its price. For example, the price/earnings ratio of a tech stock should be analyzed differently with other tech stocks. What may seem to be an overvalued stock in one sector may be an excellent value in another sector.
Put Safety First
Do no harm is an axiom of value investors. The most important guiding principle for value investors is not to lose money. One strategy they use to help preserve capital is by looking for stocks that have an appropriate margin of safety. This means not just looking for a stock that’s selling below its intrinsic value, but a stock that’s trading significantly below its intrinsic value. This gives a stock its maximum upside potential.
Value Stocks Frequently Pay Dividends
Many promising value stock candidates tend to be mature companies. When a company has achieved this phase in its life cycle, there’s less of a need to plow money back into the business. At this time, many companies choose to pass along some of its profits to shareholders by way of a dividend.
However the absence of a dividend does not mean that a stock is not a value stock, but it may have to clear a higher bar for value investors to climb aboard.
The Final Word on Value Investing
Some will say that being a value investor means having a contrarian mindset. I like to say it’s less about being contrarian than being curious. Rather than blindly following the herd or chasing a stock on its way up, a value investor should always wonder why.
Being a value investor also requires patience because once you identify a stock that’s trading below its intrinsic value it can take years for that stock’s price to rise. Being able to buy and hold stocks is an essential part of all value investing.