Value investing: 5 pros vs. 5 cons

Warren Buffett, the wealthiest businessman and a talented investor, made much of his amazing fortune on value investing. Introduced by Benjamin Graham in the 1930s, the concept suggests buying and holding undervalued stocks. With time, the market sentiment alters and the true worth comes to the surface, bringing good returns.

But as any strategy, value investing has its benefits and traps.

Pros

Fat profits. Value investing can generate a spectacular gain. Investors buy stocks underpriced and sell above their intrinsic value. As the time goes by, an underestimated asset reveals its true worth and yields fruit because market players don’t feel bearish about them any longer.

Low risks, high reward. A risk/reward ratio of a value stock is favourable, provided the stock is evaluated properly. An underestimated security is traded significantly below its valuations thus the loss-associated risk is minimised. At the same time, if a stock turns around in the investor’s favour, there’s potential for generous returns.

Cool approach. Successful value investing is based on a profound fundamental analysis, rather than emotions. An investor has to evaluate multiple metrics like P/E, P/B, D/E, etc. that eventually help them arrive at the safety margin of a stock. Margin of safety principle dictates that a stock is worth buying if its fair value is well below the intrinsic value.

The power of compounding. Value investing makes the most of the magnifying power of compounding. Your investments increase dramatically if you reinvest dividends and returns obtained from value companies. Thus, in the course of time, you benefit well from interest on interest. This is exactly what Warren Buffett holds dear, and we have reasons to believe him.

Reliable blue chips. Value investors consider the overall potential of a company, rather than shares and market sentiments towards them. They seek ownership in a well-established business that is able to make money and yield high earnings. As a matter of fact, value investing proponents prioritise sound and safe blue chips over small caps.

Cons

Value companies hide. Undervalued shares worth investing are difficult to identify. Estimating the intrinsic value requires a certain level of expertise and not every investor has it. Even if they do, there are a lot of things beyond investors’ control like changes in management and behaviour of peers. You can analyse all the fundamentals but there’s no guarantee you’ll make the right decision.

Patience. Value investing is not for everyone. Those who want to reap the benefits quickly may find it challenging. Sometimes proponents of this strategy have to hold their positions for years until the market sentiment changes in their favour. But in the end, patience may bring high reward.

The pitfalls of waiting. Having ownership in a value company can be fruitful, but it can equally be a dead end. Value traders can hold stocks for a lifetime but never see them turn around. In such a no-win situation, investors are forced to quit with a loss.

Rowing against the stream. Value investing requires self-confidence meaning that you’ll have to go against the flow. In a sense, value investors are very similar to contrarians. At least both of the styles are based on looking for price discrepancies and acting against the prevailing sentiment. Anyway, to see your investments bringing hardly any returns is quite a pressure.

Poor diversification. Value traders may invest in all sectors that underperform now but are predicted to turn around in future. This is how value investing proponents saw bank shares in 2009. However, committing funds to several sectors only means that a portfolio is poorly diversified, thus exposed to substantial risks.

Conclusion

Value trading can be profitable if it suits you as a strategy. It requires patience, financial knowledge and confidence, but at the same time, it rewards generously. Consider the drawbacks and the advantages. Does the strategy suit you?

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