What is value investing?
Value investing is a long-term investment strategy in which stocks are selected that are trading below their intrinsic value or book value. Value investors achieve this by looking for companies that are cheaply valued for reasons that do not appear justified in the long term. These stocks usually have a low multiple, e.g. of their earnings (e.g. P/E ratio) or assets (e.g. P/B ratio). This approach often requires a contrarian or anti-cyclical mindset and a long-term investment horizon.
Generally speaking, the investment strategy of a value investor is comparable to a person who only ever buys products on offer. The quality of the product is the same. A winter coat, for example, can sometimes be bought at a 50% discount during the winter sales. This is because there is less demand for winter coats after the winter. The price of a share can also change at certain times, even though the value of the company has not changed. The demand for a company’s shares can decrease, for example, due to negative news or a negative market environment, which has nothing to do with the company itself.
However, as there is no advertising for special promotions for shares, extensive financial analysis and valuation methods are sometimes needed to identify value shares. The selection of shares requires a very good strategy, diligence and time. It also requires a great deal of specialist knowledge in the specific sectors. A good, specialized asset manager can be of great help with their expertise in selecting value stocks.
Well-known value investors include Warren Buffet, Benjamin Graham (who is also regarded as the founder of value investing), David Dodd, Charlie Munger, Christopher Browne and Seth Klarman.
Characteristics of value shares
A number of key figures can be used to determine the actual value of a share. The selection of shares requires a combination of financial analyses, but also fundamental factors such as the business model, the brand and the competitive advantage. The following characteristics, for example, can help with the analysis:
- The price-to-book ratio ( P/B ratio) or book value, which measures the value of a company’s assets and compares them with the share price. If the share price is lower than the value of the assets, the share is undervalued, provided the company is not in financial difficulties.
- The price/earnings ratio (P/E ratio ), which shows the relationship between the company’s earnings performance and the share price in order to determine whether the share price reflects the entire profit or whether the share is undervalued.
- Free cash flow (FCF): If a company generates free cash flow, it has money left over to invest in the company’s future or to pay off debts, pay dividends and buy back shares.
- The debt-to-equity ratio (D/E) indicates the extent to which a company’s assets are financed by debt.
- Buying and selling by insiders: When insiders (e.g. employees) buy shares, it is often assumed that the company is currently doing well.
- Profit reports
Of course, there are many other key figures and factors that are included in such an analysis (e.g. equity, turnover and earnings growth).
Why shares are undervalued or overvalued
Value investors partially reject the efficient market hypothesis. The efficient market hypothesis states that share prices already take into account all information about a company so that their price always reflects their value. Value investors believe that stocks can be overvalued or undervalued in the short term for a variety of reasons. Benjamin Graham believed in the theory of efficient markets. However, according to Graham, the irrationality of investors and other factors provide room for human error, such as the inability to predict the future. Fluctuations in the stock market therefore always offer the opportunity to buy undervalued or unpopular shares, giving investors a margin of safety between the price paid per share and the intrinsic value per share.
Value investors like to behave in the opposite direction to other investors or counter-cyclically. Value investors usually do not buy shares that are in vogue. They prefer to invest in unknown companies, provided the key financial figures are right. Known stocks are analyzed when their prices have fallen because value investors believe that such companies can recover from setbacks if their fundamentals remain good.
There are many reasons why a share trades at a discount to its intrinsic value. However, the most common reason is a short-term earnings disappointment, which often leads to a significant drop in the share price. Often these disappointments can trigger a strong emotional reaction from shareholders, who sell their shares for fear of further negative developments. Value investors recognize two things: first, most companies are in it for the long haul, and the actual impact of short-term earnings declines on a company’s long-term value is often small. Second, they recognize that, on average, most corporate earnings turn around over time, meaning that in the long run, catastrophic earnings declines are often offset, and conversely, extremely strong earnings growth tends to slow down.
Often the reasons for such share sales by investors are of an emotional nature, i.e. shares are sold for irrational reasons and in panic. For example, the market may overreact to good and bad news, leading to price movements that have nothing to do with a company’s long-term fundamentals. Here are some factors that can drag down a stock’s price and cause it to be undervalued:
- Market movements and herd mentality: Sometimes people invest irrationally based on psychological biases rather than market fundamentals or facts. Conversely, loss aversion forces people to sell their shares when the price of a stock falls or the overall market declines.
- Market crashes: When the market reaches a much higher than average peak, this usually leads to a bubble. As the peak is unsustainable, investors panic, leading to a massive sell-off. This leads to a market collapse (example dotcom bubble).
- Unnoticed and inglorious stocks: Some stocks are undervalued because they are not on the radar of analysts and investors.
- Bad news: Many investors sell their shares because of bad news, even though the company is fundamentally valuable.
- Cyclicality: Every company is exposed to the economic cycle (e.g. seasonality), which can affect the current profit level and share price, but not the long-term company value.
Risks of value investing
- Misinterpretation of financial reports: If the financial reports and key figures are calculated and analyzed incorrectly, there is a risk of a bad investment, which is often referred to as a value trap. When analyzing financial reports, it is important to consider all factors and accounting methods.
- Exceptional gains or losses in the income statement may be excluded from the analysis, which can lead to misinterpretations. Exceptional gains or losses are caused, for example, by legal disputes, restructuring or even natural disasters.
- Differences in the calculation of key figures: Key figures can be calculated using pre-tax or after-tax figures. Some key figures do not provide exact results, but lead to estimates. Depending on how the term profit is defined, earnings per share (EPS) can vary. Comparing different companies on the basis of their ratios can be difficult as companies use different accounting practices.
- Buying overvalued shares: An inflated price for a share is one of the main risks for value investors. Paying too much or buying a stock close to its fair market value can result in losing some or, in the case of bankruptcy, all of the money invested. Buying a stock that is undervalued reduces the risk of losing money, even if the company does not perform well.
- No diversification: This is a risk in value investing that should not be underestimated. Value investors often buy when share prices fall, preferably in a staggered manner. However, the price may continue to fall and value investors may continue to buy in order to lower the average price. As a result, individual positions can become very large and the individual security risk increases or the diversification of the securities portfolio decreases.
To avoid such risks, it is worth consulting an expert in the field of value investing, such as a specialized, independent asset manager with many years of experience.
Value investing vs. growth investing
Value stocks are different from growth stocks. Value investors look for stocks that are trading below their intrinsic value or book value, while growth investors consider the fundamental value of a company but tend to ignore standard indicators that might suggest the stock is overvalued.
While value investors look for stocks that are trading below their value today, growth investors focus on the future potential of a company. In contrast to value investors, growth investors can buy shares in companies that are trading above their current intrinsic value, on the assumption that the intrinsic value will rise and eventually exceed current valuations.
Some investors try to diversify by including both growth and value stocks in their portfolio. Others prefer to specialize by focusing more on value or growth. The two investment styles do not necessarily have to contradict each other, as it does not necessarily mean that cheaply valued stocks cannot show exceptional growth. A combination of value and growth can even be extremely profitable, but is very difficult to implement. It is worth consulting a specialist here, as a good asset manager, for example, can identify precisely such companies using appropriate analyses.