Legendary investors like Warren Buffett and Benjamin Graham have made investing in value stocks famous for their low costs and potential for long-term growth.
A value stock generally refers to holdings in a company that has great earnings relative to the stock price, with an expectation those earnings will grow steadily over time, says Jonathan J. Monjazi, founder of CEO Based Investing, a San Diego-based financial advisory.
“If a company’s product is basically a trendy idea, it is subject to the whims of the generation of people” it appeals to, says Brian Hamilton, chairman and co-founder of Sageworks, a financial analysis platform. That kind of product, he says, makes it difficult-to-impossible to forecast the company’s long-term prospects accurately, which is the key to good investing.
[See: 10 Skills the Best Investors Have.]
Value investors avoid this pitfall by buying for less than it’s worth unsexy stock that can stand the test of time, through dips in demand and shifting trends.
There’s some hard evidence value investing produces exceptional results. Noble Prize Laureate Eugene Fama and Dartmouth College Professor Kenneth French analyzed value growth from 1926 through 2015 and found that large-cap value stocks have returned an average of 11.2 percent annually, while the average return for large-cap growth stocks has been 9.4 percent.
Like any portfolio strategy, value investing isn’t foolproof or without risk, but the following tips can help get you started.
Examine the stock’s price, then its value. The price of a stock is its market value at the time, but its “intrinsic value” is the price someone should be willing to pay for it based on its “current fundamentals and long-term prospects,” says Robert Johnson, president and CEO of the American College of Financial Services and co-author of “Strategic Value Investing.”
When the market price exceeds the stock’s intrinsic value, demand eventually falls, and pricing can also drop dramatically. A value stock investor tries to avoid that by purchasing undervalued shares that are more likely to rise steadily, Johnson says. The difference between the intrinsic value and the stock price is called “margin of safety.” The bigger this is, the better.
In other words, if a stock’s price is extraordinarily expensive, it may not be the best value for your money.
Analyze the metrics. One of the most effective measures of a value stock is price-to-earnings ratio — and the higher the P/E is, the more likely the stock may be overpriced. The ratio is calculated by dividing the share price by the company’s earnings per share.
Ideally, a value investor wants the P/E to be less than 20, says Ben Schrock, president at B.A. Schrock Financial Group in Wadsworth, Ohio. But stop short of comparing one company’s P/E to another, says Bernie Nelson, a president with Style Research, a provider of investment portfolio analytics.
[See: 9 Ways to Spot Value Trap Stocks.]
That’s because different industries have different earnings growth expectations. Many may seem inexpensive but are subject to major fluctuations in the market.
Investors must be careful “to remove certain asset classes like real estate investment trusts and heavily regulated industries, like utilities, whose stocks may appear to be value stocks but that lack the growth potential that a true value stock has,” says Ron Kloth, a financial advisor with Dynamic Wealth Advisors in Tempe, Arizona.
There are other measures investors should investigate and account for: Does the stock have a low price-to-book ratio or price-to-cash flow ratio, and net current asset value, all of which indicate whether a stock is a good value, Kloth says. The best value stocks also pay dividends.
Be patient and flexible. Value investing, like all equity investing, is risky and should be part of a long-term diversified portfolio strategy. “Since risk and return are related and value stocks are more risky than growth stocks, there is a premium awarded to those who invest in value stocks,” says Derek Hagen, a financial planner and analyst with Fireside Financial in Minneapolis. “The downside of value investing is the risk. Even though you are rewarded in the long run, in the short run you are in for a bumpy ride.”
To mitigate that risk, Hagen recommends buying an index fund that is equal parts value and growth, as well an index fund that tracks a value index, against which the fund can be measured.
While investors ride out the ups and downs of value stocks, they might find another finding of Johnson’s research reassuring. He and his co-authors discovered that from 1981 through 2012, value stocks outperformed growth in 20 of those years, while growth stocks outperformed value in only 11 years.
[See: The 10 Best ETFs for Value Investors.]
At the end of the day, investors should be patient and realistic about their goals. Like any equity holding, you also want to be flexible. “No one strategy works all the time,” Kloth says.
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