Is it time for a return of value investing?
Over the past decade, growth stocks have largely driven the steady increase in market valuations. The low-interest, low-inflation environment paved the way for mega companies and start-ups alike to grow exponentially, disrupting industries and reaping large cash flows in the process. It’s no wonder that many investors tilted their portfolios towards a growth bias.
But the tide may now be turning.
With global interest rates on the rise, increased inflation and volatility in the markets, many analysts are now speculating that the time is ripe for a resurgence in value stocks which have underperformed their growth counterparts.
Value investing in a nutshell
Value investing is a cornerstone investment strategy, which is based on identifying stocks that are believed to be undervalued relative to their intrinsic worth. Value investors, famous examples include Benjamin Graham and Warren Buffet, look for companies with strong fundamentals, but with low price-to-book and/or price-to-earnings ratios. Basically, value investors look for companies whose stocks are trading below what they think the company is worth.
By its nature, value investing tends to be a buy-and-hold approach. You need to wait long enough for the markets to recognize that the company is undervalued. If the company maintains strong fundamentals, then its share price should increase to the point where it is fairly- or overvalued.
Determining a company’s fundamental value can be tricky. Some investors focus on a company’s current earnings and holdings, while others consider future growth and cash flow. With so many ways to interpret intrinsic value, it becomes important to do your research so that you understand your potential investments.
Identifying value investing opportunities
There are three things you should consider when evaluating potential value stocks.
First, search for solid companies that have a strong track record of growing revenue and earnings. Value stocks are often found in well-established industries such as Finance, Consumer goods and Energy, but they can be found in any industry.
Second, examine the company’s financial metrics. There are a few popular metrics that Value investors like to focus on, including:
- P/E (price/earnings) ratio—this ratio measures a company’s current share price relative to its per-share earnings; essentially how much you would have to invest to earn a dollar of the company’s earnings.
- Earnings yield—this yield is the inverse of the P/E ratio. It indicates the company’s earnings-per-share over the previous 12 months and helps determine how high your earnings could be relative to the share price. [MB: Note these are the company’s earnings, not “your earnings” per se. This could be misinterpreted to be a dividend yield]
- Fair Value—this theoretical calculation estimates the appropriate share price of a company, based on its earnings and growth rate. If a stock is trading above its Fair Value, it is considered to be trading at a premium; if its trading below its Fair Value it is considered to be trading at a discount.
Third, a key point in any investment strategy is to research a company beyond its numbers. While it’s important to understand the financial background of a potential investment, the numbers only paint half the picture. What does the company actually do? Where are its revenue streams coming from? How are its competitors doing? What is going on in its general industry? Asking probative questions like these will help you get a better overall sense of how the company operates and what challenges or opportunities it could face in the long term.
It can also help you avoid “value traps.” A value trap is a company that may have value characteristics, but its declining industry or product make it unlikely to realize any significant gains. For example, a company that sells flip phones may have strong fundamentals because of historical contracts, but its now-obsolete product means the company is no longer offering anything of value to the marketplace. Looking at external factors like these can complement fundamental research and help you make a more informed investing decision.
Hayes, Adam. “Value Investing Definition.” Investopeida. Jan 9, 2019. https://www.investopedia.com/terms/v/valueinvesting.asp
Wigglesworth, Robin. “Value stocks show signs of turning a corner in 2019.” Financial Times. Dec 4, 2018. https://www.ft.com/content/480aff2a-f7c4-11e8-8b7c-6fa24bd5409c
Graham, Jed. “Value VS Growth Stocks: Growth Continues to Crush Value Investing, But This Big Risk Looms.” Investor’s Business Daily. Oct 4, 2018. https://www.investors.com/research/value-vs-growth-stocks-value-investing-lags-growth/