What are value stocks?
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Value stocks are securities underpriced relative to their intrinsic value. The reasons for this undervaluation could be perceived low stock price relative to relevant financial fundamentals, such as debt levels, revenues or a low price to earnings ratio. Stocks may also be considered underpriced relative to their competition or be part of an industry that exhibits generally strong fundamentals but is priced below overall market potential.
Value investing explained
A value investing strategy is similar to a buy and hold strategy in that it’s typically a long-term investment. A particular stock may be undervalued due to recent poor performance or negative financial reporting. It may be a long time before the broader investment market recognises the stock’s intrinsic value.
Being a value stock means that long-term intrinsic value may not be inherently obvious to investors as a whole. Through careful analysis of financial fundamentals such as earnings, cash flow and the price to earnings ratio, value investors attempt to identify these stocks earlier than the market and invest before the price catches up to the actual value.
In many instances, value stock examples are companies that for one reason or another have experienced some sort of short-term downcycle which has negatively affected their stock price, but have strong fundamentals and could be expected to outperform in their sector over the long run.
In other cases, companies that have some form of competitive advantage, such as emerging market potential or protected intellectual property, could be defined as value stocks. But the broader market has yet to recognise any advantage.
Value investing history
Value investing was first theorised by Columbia Business School professors Benjamin Graham and David Dodd. The ‘Oracle of Wall Street’, Warren Buffet, was one of their students.
Buffet later described the crux of value investing as the belief that the market is not always efficient. Opportunities exist that are underpriced relative to their intrinsic value and that a value investing strategy is able to identify these inefficiencies and capitalise on them in the long-term.
Later in his career, Buffet also embraced the idea that some value stocks may not exhibit abnormally strong financial fundamentals currently, but could possess intrinsic long-term competitive advantages which are not easily recognisable or repeatable by their competitors.
Value vs growth investing
Growth investing seeks to identify stocks that may or may not be overvalued currently but have the potential for strong continued earnings growth. On the other hand, value investing seeks to identify market inefficiencies where the current price of a stock does not represent the intrinsic value of that security. The stock may be experiencing a price decline that is overrepresented due to external factors, such as market shock, recession or inflation, but is in position to outperform in its sector.
An important metric to value investing is identifying stocks that are undervalued because they’re underperforming for good reason. Similarly, stocks which experience explosive growth may have done so due to speculative reasons and could underperform in the long run.
