Value investing is an investment strategy that involves finding hidden gems in the stock market. This strategy is similar to finding good products at a discount store. For instance, buying a $20 headphone for $15 is a great deal. Can a similar approach be applied to the stock market? Yes, but stocks are not as simple as headphones.
How Value Investing Works
Value investors first evaluate the intrinsic value of a company. This helps them determine if the current market price is lower than its actual value. For example, let’s assume Apple’s headphones are priced at $100. A value investor might evaluate them at $150. In this case, they believe the stock should rise by 50% to reach its fair market value.
Importance of Valuation
Valuation requires various data such as financial reports, valuation metrics, and competitor analysis. It’s a challenging task as two stock analysts might have opposing opinions despite looking at the same information. However, through this process, value investors draw their own conclusions.
Why Stocks Become Undervalued
There are several reasons why stocks become undervalued, including market corrections, bad news, neglect, and excessive losses.
Market Corrections
A market correction occurs when major indices drop more than 10% from their peak. This can cause some stocks to suffer more than others. Such situations present buying opportunities for value investors.
Bad News
Negative headlines can drag down stock prices. For instance, Alphabet’s stock fell in early 2024 due to investor concerns about falling behind in the AI race. However, Alphabet’s stock quickly rebounded after its earnings announcement. Value investors bought Alphabet stocks cheaply during this period.
Neglect
Some stocks are neglected due to lack of market attention. These stocks are usually small-cap with solid financials. For example, Celsius Holdings and Elf Beauty were unnoticed for years but recently surged over 1,000%.
Excessive Loss Expansion
Stocks experience sharp price fluctuations during earnings seasons. Value investors see these drops and panic as long-term buying opportunities. After a poor earnings announcement, if a stock drops 20%, they might buy it and wait for the company to recover.
Common Valuation Metrics
Value investors look at several metrics to determine if a company offers a good buying opportunity. Key metrics include PER, PBR, and free cash flow.
- PER: Uses price and earnings per share to calculate valuation.
- PBR: Determines valuation using price and book value per share.
- Free Cash Flow: Shows how much operating cash flow a company has after considering capital expenditures.
Pros and Cons of Value Investing
Value investing has several pros and cons.
Pros
- You can minimize risk by finding stocks with good safety margins.
- There is potential to achieve returns that outperform the stock market.
- Many value stocks pay dividends.
Cons
- Value stocks may underperform during economic booms.
- It may take years to see significant returns from some value stocks.
- Value investors might miss out on momentum stocks.
Common Mistakes in Value Investing
While value investing can lead to higher returns, several mistakes should be avoided.
Not Buying and Holding Long-Term
Buying value stocks requires a multi-year perspective. Don’t rush to sell stocks when bad news arises; maintain a long-term outlook.
Following the Crowd
Value investors move left when everyone else moves right. Chasing momentum stocks can lead to profits, but it’s not the path of a value investor.
Lack of Portfolio Diversification
[Spread your investments across multiple stocks to reduce risk and minimize losses if one company’s performance deteriorates.
Not Conducting Due Diligence
Before buying stocks, review the company’s quarterly earnings, valuation metrics, competitors, and other insights.
Being Swayed by Emotions
Investors should evaluate the intrinsic value of a company and determine if there is a change in its long-term outlook. Don’t let short-term stock price drops influence your decisions.
Is Value Investing Still Relevant?
Value investing can still lead to high portfolio returns that outperform the S&P 500. However, thorough research is necessary to accurately find stocks that offer reasonable safety margins.
How Risky is Value Investing?
Value investing is less risky than other types of investments but still carries some risk. Stock market investments can yield significant profits, but with potential rewards come risks.
Is Value Investing Safer Than Growth Investing?
Generally, value investing is safer than growth investing. Value investors tend to choose stocks with good safety margins.
Reference: Newsweek, “What Is Value Investing?”