What is value investing and why is it important right now? With the stock market having risen in the past few years and prices being on the high side of their historic range it’s time to start looking for bargains. Value investing is exactly that – the search for stocks trading at bargain prices.
And understanding value investing is important for other reasons. If general stock prices begin to decline you’ll need to get into special situations involving stocks that are likely to resist the overall trend. Because value stocks are not part of market run-ups, they tend to do better during market declines.
What is value investing?
In value investing you buy stock in companies that are said to be undervalued. What this usually means is that the stocks are out-of-favor with current market psychology. While the price of other stocks are being driven higher because they are currently in favor with the market, value stocks are those which are largely ignored. Prices therefore, languish or decline.
The price of the stock will be low compared to its competitors based on price earnings ratio, book value or some other metric. You can compare these metrics by reading shareholder letters and the company’s financial statements.
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Value investing tends to work best with companies that have experienced a period of bad news that is largely behind them. The company’s fundamentals are strong, the markets just haven’t come around to recognizing the company’s improved position. Despite the fact that the company is solid, it’s price continues to lag within the industry. This is often a rich source of value stocks.
It’s also important to understand that value investing is not just about buying shares in companies simply because the price is low. The stock price may be battered for good reason, and you don’t want to jump in and buy into such a company that is only in the middle of its troubles. It does have a certain quality of panning for gold.
Why value investing works
One of the big reasons why value investing works is that you’re buying into the shares of companies where the activity has been quiet. That provides opportunity to thoroughly investigate the company and to assess it’s long term potential. There’s ample time to buy these companies at bargain prices.
The market “herd” hasn’t discovered the stock yet, and if the fundamentals of the company are strong the price rise might be quite spectacular when they do. A sudden rush of capital into the stock of any company can push it up to multiples not typically seen with most stocks. You’ll be buying the prices low, riding them higher, and selling after a substantial profit. The key is always getting in before the crowd does.
Another reason value investing works is that you will be able ride out declines in the stock market as I said. Since the stocks you are buying are not high-flyers during bull markets, their declines tend to be less severe in declining markets. In addition, since they are already priced below market, they can sometimes rise even in declining markets. That puts the very long-term working in your favor and allows you to relax during market declines.
Sitting out market trends
If you are an active market trader you may find it difficult to sit on the sidelines and ignore general market trends. Many investors tend to hop into the current hot stocks on Wall Street. This is one reason why smart people lose money in the stock market. To invest in value stocks means to ignore the trend the rest of the market is following. That can be difficult to do from a psychological standpoint.
Value investing is a very long-term process. You may buy a stock at a very low price and then have to sit on it for several years in order to make a substantial profit. This is not the type of strategy that in-and-out traders tend to favor. You will build a portfolio of value stocks and then wait. It takes patience, and not all investors have that.
Staying the course
Value investing is all about patient capital. It’s about getting rich slowly! You will have to spend significant time investigating companies that are being ignored by the investment mainstream in making determinations as to what the future potential is. Not only will that take time, but you’ll have to avoid jumping the gun on a stock that could be a value stock when in fact it isn’t.
Once you have a value stock, or better yet a portfolio of them, it will be time to sit back and relax. As a value investor you won’t be chasing the market. You’ll be making your selections and sitting with them for as long as it takes. It can take years, or even a decade or more, but the returns can be handsome.
Value investing is actually one of the most time-honored ways to invest. It is also one of the most successful, and is practiced in many investment legends such as Warren Buffett.
Are you looking at value investing right now?
Love the post! Does a great job of explaining the fundamentals of value investing. I am not sure that I am a straight value investor, but maybe a value investor with a bit of seasoning thrown in here or there…Currently I am at Columbia, which is the home of value investing and the Ben Graham school of thought, getting my MBA. I think time and stats show that the value approach has such a large success rate over time that it shouldn’t be ignored.
Hi Lacy–I think it’s the most time honored strategy among serious investors. The problem with trend investing (how most people invest even though they don’t realize it) is that sooner or later the trend comes to and end. When it does, then what? With value investing, you’re a long term player in the truest sense because you aren’t riding any trends.