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Stock strategy: How value investing can make you money
Identifying undervalued stocks to score high returns
What's in this guide?
What is value investing?
Value investing involves picking quality stocks that are presumably trading below their true or “intrinsic value,” also called book value. This may give investors an opportunity to buy strong stocks at a discount.
Investments in value stocks stem from the idea that people overreact to market news hype, thereby moving the prices of some stocks in directions that don’t reflect the fundamentals and potential of certain companies.Value investors, including most famously business icon Warren Buffett, believe over time the market will recognize these companies’ real worth.
How to invest in value stocks
Value investors conduct deep financial analysis to find stocks they believe are undervalued. But there are easier ways to engage in value investing. For example, you can buy shares of exchange-traded funds (ETFs) that invest in several value stocks. This minimizes the risk of putting all your money in one or two value stocks that may fail to meet expectations. Here are some examples of top value ETFs.
- Invesco S&P SmallCap Value with Momentum ETF (XSVM)
- Invesco S&P SmallCap 600 Pure Value ETF (RZV)
- Avantis U.S. Small Cap Value ETF (AVUV)
You can also track what the top value investors are buying. Here are four of the latest value stocks handpicked by Warren Buffett and his lieutenants.
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How do I determine if a stock is undervalued?
The following are a couple of popular measures investors use to determine the true 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 the total of its outstanding stock shares 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 more free cash flow may be 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 risk. It requires you to be skilled at analyzing a company’s fundamentals. It also requires you to be 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 sound and it is undervalued in relation to its stock price, the wider market will 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. This means you’d be missing out on potential gains elsewhere.
As the financial analyst A. Gary Shilling once said, “The stock market can remain irrational a lot longer than you can remain solvent.”
How to succeed in value investing
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. 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.
Why would a stock be undervalued?
There are a number of reasons a particular stock might be undervalued, including the following:
- Stock market crashes. During market downturns like the one in March 2020, share prices of many companies with strong fundamentals drop. This may be triggered by investor fear and doesn’t necessarily reflect a company’s performance. But it also means you can buy these stocks at a discount before they rebound.
- General market behavior. If the price of a certain share declines, some investors may panic sell, causing the stock to plummet without justification.
- Unpopular companies or industries. Industries like tech and green energy dominate headlines. This can cause investors to ignore undervalued companies in “boring” industries.
Value investing vs growth investing
The opposite of value investing is growth investing. This involves investing in companies that are expected to grow rapidly, regardless of how their fundamentals measure up to their share price.
An example would be investing in a new tech startup that may still be operating at a loss but is poised to secure a large market share or dominate an emerging market.
During prolonged bull markets (and especially stock market bubbles), value investing has historically offered lower returns than growth investing as investors are generally more interested in chasing growth stocks. However, value investing has often outperformed the market following stock market crashes or in the period following a stock bubble bursting.
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