Value investing

What is value investing?

Value investing is a type of investing strategy that involves picking stocks or securities that are currently trading below their true or “intrinsic value”. It is based on the idea that markets are not necessarily completely rational and that there are companies and stocks out there that are currently undervalued in relation to their fundamentals and therefore trading for less than their book value.

It’s a popular strategy for many large investment funds, including Warren Buffett’s Berkshire Hathaway, and uses a long-term, qualitative approach to investing. It’s often considered a contrarian strategy as it involves finding companies that have been ignored by the market and avoiding stocks that are currently overhyped or dominating headlines.

Value investing is perhaps best summarised by Buffett himself, who says, “It’s better to buy a great company at a fair price than a fair company at a great price.”

How does value investing work?

In simple terms, value investing means finding companies on the stock market whose current share price is undervalued compared to the company’s actual value. An everyday analogy would be buying an item, such as a fridge, on sale. The “fundamentals” of the fridge don’t change during a sale period; you’ll simply be paying less for the exact same thing.

The same idea can be applied to stocks. Stock prices change all the time, even if the underlying fundamentals of the company have not, and value investing is the strategy of identifying and buying stocks that are “cheap” in anticipation of them rising once the rest of the market catches on.

Why would a stock be undervalued?

There are a number of reasons a particular stock might be undervalued, including the following:

• Stock market crashes. Whenever there’s a wider stock market crash, like what happened in March 2020, the share price of most companies drops. This is generally a result of investors getting scared or losing faith in the market as a whole and does not necessarily reflect how a company is performing in real life. As a result, companies with strong fundamentals may see their share price drop along with the rest of the market and lead to them being undervalued.
• General market behaviour. If the price of a certain share declines, some investors may panic and see that as a reason to sell, leading to the price dropping further. This is called a selloff and can lead to situations where a company’s share price plummets without real justification. Such stocks can often end up undervalued and may rebound once the market calms down.
• Untrendy companies or industries. The stock market features companies from a huge range of industries, and it’s no surprise that some are more popular with investors than others. Industries such as tech and green energy often dominate headlines, and this can lead to investors ignoring undervalued companies with strong fundamentals in “boring” industries in favour of chasing the next big tech stock.

How do I determine if a stock is undervalued?

The following are a couple of popular measures investors use to determine the “intrinsic value” of a stock or company:

• Price-to-book (P/B) ratio (or “book value”): This is the value of a company’s assets (minus debts) compared to its current stock price. A company may be considered undervalued if its stock price is lower than the total value of its assets (i.e. it has a P/B ratio under 1).
• Price-to-earnings ratio (P/E): This is the ratio of a company’s revenue to its current share price and is calculated by dividing the stock price by the earnings per share (EPS).
• Free cash flow: Free cash flow is the amount of money a company has once you’ve subtracted all costs and expenditures, such as operating expenses and business purchases. Companies with free cash flow are in a better position to grow their business.

What are the risks of value investing?

While value investing is generally considered a relatively conservative approach to investing, it’s not without its risks. It requires you to have a high level of understanding regarding how to analyse a company’s fundamentals and relies on you being able to access accurate and up-to-date information on a company’s finances and operations.

If your analysis is incorrect or you’ve applied the wrong metrics to measure a company’s intrinsic value, you may actually end up overpaying for the stock. Worse still, even if your analysis of a company is “correct” and it is undervalued in relation to its stock price, the wider market will still need to agree with this sentiment, otherwise the share price is unlikely to go up.

Value investing means you’re effectively betting against the market, and this is always a somewhat risky approach. You may find that your value investment stays stagnant for an extended period or even declines in value, and this means you’ll be missing out on the potential gains that may be on offer elsewhere.

As the financial analyst A. Gary Shilling once said, “The stock market can remain irrational a lot longer than you can remain solvent.”

What are some value stocks?

Value stocks are those that are trading at a lower price compared to its underlying fundamentals, such as its P/B or P/E ratio. Value stocks are often found in established, but unexciting, industries such as energy, construction or finance. Examples of value stocks may include large financial corporations such as JPMorgan Chase or Lloyds, which both have lower P/E ratios compared to the average S&P 500 or FTSE 100 company respectively.

What type of investor does value investing suit?

In order to be a successful value investor, it’s likely you’ll need to be patient, analytical and composed. Value investing involves lots of research and critical thinking, and it is inherently a long-term investing strategy. This means it won’t suit emotional or restless investors or those who don’t have the time or resources to work out if a company is undervalued.

Frequently asked questions

• Is Warren Buffett a value investor?

  Yes, Warren Buffett is considered to be the most famous, and most successful, proponent of value investing, which he picked up under the tutelage of Benjamin Graham. Graham, along with David Dodd, pioneered value investing at Columbia University, and in their 1934 book Security Analysis.

• Does value investing still work?

  Yes, you can still have success with a value-investing approach, and there’s no reason that value investing won’t work as a strategy in the future. However, depending on the state of the market, there may be more profitable strategies available, but they will likely also come with a higher level of risk. During bull markets, value investing may offer lower returns, but they may also help insulate against stock bubbles.

• Can value investing make you rich?

  Yes, you can still make money using value investing, especially if you’re patient and can maintain a long-term approach to investing. Historically, value investing has outperformed the market by around 2% each year, based on analysis done by the American economists Eugene Fama and Kenneth French, and it has been used with great success by investors like Warren Buffett.

• Is value investing dead?

  This will depend on who you ask, but many experts believe value investing is still a valid strategy, despite the popularity of growth investing. According to investment firm AQR, “While undoubtedly many systematic approaches to value investing have suffered recently, we find the suggestion that value investing is dead to be premature.”