Value investing strategy: how to find undervalued stocks
Many of the most successful and famous investors of all time have relied on value investing as the bedrock of their approach to money management. But what is value investing and how does it work?
Here is a guide to value investing, explaining what the discipline is, how it works and the pros and cons of such a strategy.
Value investing is one of the most time-honoured and trusted methods of approaching the financial markets.
The guiding principles of the movement espoused by such well-known names as Warren Buffett are that some companies are undervalued or often ignored by the market and fleeting macroeconomic influences, and offer investors potentially lower risks and high rewards.
Investing in value stocks is a strategy aimed at stripping out the temporary impulses and emotional factors that often mislead investors, and instead focuses on the hunt for underlying or intrinsic value.
The favoured companies of value investors are ones that have a solid market position, protection from competition, a competent and stable management team, and minimal reliance on debt and hype to fulfill their business objectives and produce value.
It is the art of bargain-hunting in the stock markets, pushing investors towards long-term thinking and value creation over short-term manias and price surges, to provide, in theory, more reliable returns over time.
“Price is what you pay; value is what you get,” said Benjamin Graham, author of The Intelligent Investor and the godfather of the discipline, who inspired Buffett.
Value investing: key metrics
Below are some of the key metrics that can help investors to find the right value stocks to invest in.
While none of these measures provides an absolute picture of a company’s relative value, they can help guide investors towards companies with an earnings profile and relative share price that are attractive under a value investing framework and assess whether they are under or overvalued.
Price to earnings (P/E) ratio
The price of so-called growth stocks is often less correlated with the company’s underlying earnings. For value stocks, investors look to see a closer relationship between the income of a firm and the price of its shares.
Price to book (P/B) ratio
This is another metric based on the relative value of a stock on the market against its book value, or how much it is actually worth on paper. A smaller multiple is one figure that can help investors discern between overvalued shares and those that fly more under the radar, although caution is needed.
Discounted cash flow (DCF)
Discounted cash flow is a valuation method that enables value investors to measure the present value of a share discounted against its future income using a standardised discount rate, typically that of government bonds or a similarly supposed risk-free asset as a baseline.
Using estimates of future cash flows discounted to their present value as a valuation technique enables investors to evaluate a given opportunity’s potential growth against its current price – if the DCF is above the current cost, it could offer greater future returns.
Stock prices are the result of a combination of factors, ranging from a firm’s profits to investor sentiment and macroeconomic volatility.
Value investors seek to strip out such factors and hone in on the underlying, or intrinsic, value of a specific company to distinguish between these external short-term influences and the long-term financial prospects for returns.
Intrinsic value can be calculated using a variety of methods, including a DCF analysis, a valuation based on assets, or other metrics, such as P/E ratio.
Margin of safety
The margin of safety is a critical concept in value investing. It is a measure of the difference between the intrinsic value of a stock and its market price, a gap that tells investors how much the asset is valued, relative to its underlying appeal.
What are the advantages of value investing?
Investing in value stocks offers a number of key advantages over other approaches to investment.
According to analysis from investment fund Anchor, if one were to have invested $1 each in value and growth stocks in December 1927, today the value stocks would be worth nearly 18 times as much as the growth stocks.
“The 1970s oil crisis, the tech bubble of the 1990s and the global financial crisis of 2008 are all events that, for better or worse, were defining periods in history with far-reaching economic impacts,” the analysts said.
“Through it all, value investing has long held a structural advantage over growth investing when considered over multiple market cycles.”
Here are some of the key reasons why value investing is relied upon by the best and brightest in the financial industry.
As value investing aims to strip out many of the short-term volatile factors that can impact the price of an asset on a day-to-day basis, it can provide investors with a superior risk-reward profile.
Because such stocks are typically undervalued or cheap relative to their perceived value, investors face comparatively limited downsides and much greater rewards than if they were to base their decisions on passing market trends or emotional decision making.
Trading frequently comes with risks but also associated costs.
As value investors base their decisions on the long view of where they think value can be created, they bypass the brokerage fees and other costs associated with following the market, and can ignore the daily gyrations in stock prices.
Power of compounding
One of the most powerful aspects of a value investing strategy is the ability to compound returns.
By reinvesting the gains made over a longer horizon, the returns profile of a value investment can offer greater returns than short-term profit taking or trading.
The drawbacks of value investing
By honing in on undervalued stocks, investors run the risk of missing out on massive growth potential of industries that are just emerging or poorly understood.
Warren Buffett has famously passed on several of the biggest technology stocks this century, because their markets were deemed by the Oracle of Omaha to be too open to competition or difficult to understand.
High research efforts required
Unearthing value stocks to buy is a tough business, and one that takes a significant amount of time and expertise on the part of the value investor.
Lack of diversification
Value investments are typically concentrated in specific companies that investors believe offer significant upside at their current undervaluations.
Given the focus on a small selection of names and the difficulty of finding value stocks, investors can be overexposed to a limited number of firms and miss out on the benefits of diversifying their portfolio.
What are the largest value investing ETFs?
Here are the three biggest exchange-traded funds (ETFs) focused on value investing strategies by assets under management (AUM).
Vanguard Value ETF (VTV)
The Vanguard Value ETF is the largest value investing fund by assets under management, with total assets of $84.6bn.
The fund tracks the performance of the CRSP US Large Cap Value Index, which gives an indication of the investment return of large-capitalisation value stocks, with an expense ratio of 0.04%.
iShares Russell 1000 Value ETF (IWD)
The iShares Russell 1000 Value ETF managed by BlackRock targets stakes in US large and mid-cap stocks that are considered to be undervalued relative to similar companies in the market.
It has total assets under management of $54.3bn and an expense ratio of 0.19%.
Vanguard Small-Cap Value ETF (VBR)
The Vanguard Small-Cap Value ETF is the third-largest value investing fund by assets, with AUM of $24.9bn.
This ETF focuses on smaller value investing opportunities in the US market by tracking the CRSP US Small Cap Value Index, and it has an expense ratio of 0.07%.