What Is Value Investing?
Value investing is an investment approach whereby the investor purchases stocks they believe are undervalued. The value investor aims to make a decent return while minimizing risk.
Value investors will commonly assess the annual and quarterly reports of a company to make a valuation. The price/book value, price/earnings ratio, earnings stability, dividend record and more may be assessed when determining the value of a company.
Some of the most successful investors of all time employ the value investing approach, as I will explain further below. Now that you know that basics of value investing, I will explore the pros and cons.
Advantages of Value Investing
Value investing is my preferred investment strategy and forms the basis of my investment methodology. I will now provide a few advantages of employing this strategy.
High Returns Are Possible
Value investors are known to achieve some of the most astounding stock market returns in history. Average returns of 15-20% annually are not unheard of.
Fear and greed drives many investors to push prices to super-inflated highs and drive them to ridiculous lows. Value investors exploit this and generally purchase after the market falls in price, or when they determine the stock to be undervalued, to maximize profits.
The market will always reveal a stock's true value over the long-term. As legendary value investor Benjamin Graham once said: “In the short run, the market is a voting machine but in the long run it is a weighing machine”.
Essentially, a stock's market price is determined by investor sentiment in the short term; however, the true price will always be revealed over time.
Why is this important to value investors? According to this methodology, you have an opportunity to attain above average returns when correctly judging the value of a company.
Provides a Margin of Safety
The margin of safety principle was popularized by legendary value investor Benjamin Graham. When employing a margin of safety, you will only purchase securities when their market price is greatly below their intrinsic value (what you believe the stock is worth). Buying a stock below the perceived intrinsic value provides you with a margin of safety.
Graham would buy stocks trading at $0.50 that he believed had an intrinsic value of $1.00. This provided him with a cushion against market dips, as he was effectively buying stocks at a discount.
The margin of safety principle was defined by Graham in his book “The Intelligent Investor” (1949). This principle was devised by Graham during the great depression. A time when many people were losing money in the stock market, and anyone returning a profit was doing well.
Buying within the margin of safety does not guarantee the stock price will go up; however, it will limit your losses substantially should the stock price fall. While concurrently providing an opportunity to return a significant profit, should the market properly value the stock.
Disadvantages of Value Investing
While value investing has many advantages, any investment strategy has its disadvantages, as I will explain below.
Requires Careful Stock Selection
There is the potential for your stock to remain undervalued by the market for a prolonged period when applying the value investing approach.
Essentially, you are foregoing average market returns, in the hope of attaining above average returns. To reiterate, improper stock selection could see your portfolio remaining stagnant for a prolonged period, or even falling in price. This is important to keep in mind when considering this approach.
Can Be Time Consuming
Finding an undervalued company can be tedious. It may take hours of research depending on where you look and the strictness of your investment criteria.
I personally only buy stocks that meet strict criteria. When scanning the All Ordinaries index (Australian equivalent of the S&P 500) recently, only 4/500 stocks met the strict value investing criteria. This shows the level of dedication needed to find potentially undervalued stocks.
Websites such as The Motley Fool are useful for finding companies that are potentially worth looking over further; however, is important to always look over a company within consideration before buying.
There are also websites available that list the larger index’s such as the S&P 500 or the All Ordinaries Index. Stock analysis is a more efficient activity when you know where to look, and what to look for.
Requires a Strong Temperament
It is important to remember when investing, you need to think for yourself. As Warren Buffett has said: “Success in investing doesn’t correlate with IQ,” “Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”
Many people fall victim to their emotions when investing, particularly fear and greed. Consequently, buying when the market is doing well, out of greed. And selling when the market is falling, out of fear of losing it all.
This investment strategy requires a strong temperament and the willpower to think for yourself. Even when things are looking bleak. The inability to do this could see you selling when you should be buying or vice versa.
Successful Value Investors
Warren Buffett has achieved average returns of 20.9% annually over the past 50 years while employing a value investing approach. This is one of the best long-term track records in history.
Benjamin Graham averaged returns of 14.7% annually versus 12.2% for the market as a whole. This was achieved over 20 years from 1936-1956 while he ran his investment counselling firm Graham-Newman Corp. For more info on Benjamin Graham, visit the link.
Value investing has proven to be successful for many investors; however, this strategy is not for everyone. Value investing requires a lot of research, careful stock selection and the ability to go against the crowd.
I believe that any serious investor should educate themselves on the value investing strategy, regardless of their intent to employ it. I have outlined the pros and cons of value investing below.
Advantages of Value Investing
- High returns are possible
- Provides a margin of safety
Disadvantages of Value Investing
- Requires careful stock selection
- Can be time consuming
- Requires a strong temperament
Visit the How to Invest in Stocks for Beginners post to learn more about stock market investment.