What is Value Investing?

Value investing is like searching for a bargain at a garage sale…

People who frequent garage sales like to find hidden gems — objects that are on sale for a price they believe is less than the item’s true value. Similarly, value investors believe that some stocks are undervalued by the market — They see those stocks as buying opportunities.

Value investing is the strategy of buying stocks when they’re selling for less than the investor they’re worth. Investors buy these stocks because they believe that the market is undervaluing them, given their fundamentals, and that the price will eventually increase. Value investing often goes hand-in-hand with buy-and-hold investing, which is when an investor buys a stock and holds it for many years.

Value investing is like buying something when it’s on sale and holding onto it for many years. When someone engages in value investing, they purchase stocks they believe are undervalued.

Investors can use a variety of factors to decide whether they think a company’s stock is undervalued. They might look at the company’s book value, which is the difference between its assets and its liabilities. They may also consider the company’s earnings to ensure that it’s growing and the growth is more or less sustainable in their opinion.

When investors participate in value investing, they often hold stocks for many years. They don’t expect these undervalued stocks to shoot up in value so they can sell them for a profit right away. Instead, they hold them in their portfolio as they increase in value over the years.

Benjamin Graham is considered the father of value investing. He developed the concept as a professor at Columbia Business School in the 1920s. He and his coauthor David Dodd wrote the book Security Analysis in 1934, which is now considered a classic text on value investing.

Graham’s method of value investing includes using several different screening techniques to help identify stocks that are undervalued and will likely increase in price later.

Benjamin Graham’s screens for value investing are:

• The price-to-earnings ratio (price compared to its earnings per share) of a stock should be less than the inverse of the yield on a corporate bond with a AAA rating. AAA is a rating a debt security can receive to indicate the company is highly creditworthy. A bond’s yield is the ratio of its interest payments to its current value in the market.
• The price-to-earnings ratio of a stock should be less than 40% of the average price-to-earnings ratio for the past five years.
• The dividend yield (a ratio of how much of the company’s earnings it pays out in dividends compared to its stock price) of the stock should be more than two-thirds of the yield of a corporate bond with a AAA rating.
• The stock’s price should be less than two-thirds of its book value (a company’s book value is the difference between its assets and its liabilities).
• The stocks’ price should be less than two-thirds of the net current assets (the difference between a company’s current assets and its current liabilities).
• The company’s debt-to-equity ratio (total debts divided by total equity) should be less than one.
• The company’s current assets should be more than twice its current liabilities.
• The company’s debt should be less than twice its net current assets.
• The growth of the stock’s earnings per share should be more than 7% over the past 10 years. Earnings per share is the company’s entire profit divided by the number of outstanding shares.
• The company should have no more than two years of negative earnings over the past 10 years.

When it comes to using Graham’s screens to find value investments, there are a few extra things to keep in mind:

• Have a long time horizon: Value investing generally involves buying stocks and holding them for five years or more.
• Choose screens wisely: An investor doesn’t have to use all of Graham’s screens when it comes to choosing stocks. In fact, using too many might eliminate stocks that are attractive for value investing.
• Diversify your portfolio: Value investing isn’t just about buying one stock and holding it for years. The more diversified an investor’s portfolio, the more they reduce their risk of loss if one stock performs poorly.

Value investing as invented by Benjamin Graham relies on four primary principles:

1. Intrinsic value: Every stock has an intrinsic value, which is what it's truly worth regardless of its market price.
2. Margin of safety: The greater the margin between a stock’s intrinsic value and its market price, the better.
3. Mr. Market: Mr. Market represents a fictional and irrational investor who makes investment decisions based on his emotions. Value investing requires a rational investment strategy to contend with the volatility of Mr. Market.
4. Diversification: Value investing is best done with a diversified portfolio of at least 40 different stocks at a time. This diversification helps to reduce risk.

Warren Buffett is the CEO of Berkshire Hathaway Inc and a renowned investor, in part because of his great success as a value investor. Warren Buffett attended Columbia Business School, where he learned value investing directly from Benjamin Graham. In addition to Graham’s value investing principles, Buffet has a few of his own core tenets that he follows:

1. Business tenets: According to Buffett, investors should buy stocks in companies with a simple and understandable business. In other words, if you don’t understand what a company does, it may not be the right investment. These companies should have consistent historical growth and good prospects in the future.
2. Management tenets: Buffett recommends investing in companies whose managers are candid, trustworthy, and strong leaders. He looks for leaders who reinvest in the company to help it grow.
3. Financial tenets: Buffett invests in companies with a high return on equity (net income divided by stockholder equity). Additionally, companies should have high and stable profit margins (meaning the percentage of earnings that a company keeps in profit). It’s not necessarily about how much the company makes, but about how the earnings compare with equity and expenses.
4. Market tenets: Buffett believes in taking a more conservative estimate of earnings. After coming up with a projection for future earnings of a company, Buffett discounts them using the risk-free rate (the rate on riskless government securities). Using a discount rate helps to figure out the value of future earnings compared to today’s dollars.

Value investing involves buying stocks that are perceived to be undervalued in the market with the expectation that they’ll increase in value. These stocks are often those with an established track record and are generally perceived as lower risk than growth stocks, but they currently are valued less than others in the market.

Growth investing is the opposite in some ways — Instead of buying stocks when they’re priced below a certain perceived value, growth investors often buy stocks that are priced higher relative to the rest of the market. Growth stocks often have higher than average price-to-earnings ratios. Because these companies are expected to grow faster than the overall market, investors are willing to pay more for these stocks.

Growth investing tends to involve more volatility and risk than value investing. When an investor buys a stock that’s already priced higher than the rest of the market, there’s a greater chance that the price will fall. With value stocks, on the other hand, the price is already low. The chances of the price dropping more are slimmer. However, sometimes some value stocks are priced low for a reason and they can continue to fall individually or as a group during market downturns.

When comparing two very different investing strategies, investors are often going to have one very important question: Which is better? The frustrating answer is the same that applies to many other questions about investing: It depends.

According to Merrill Edge, one of the nation’s largest brokerage firms, value and growth stocks shine at different times. When interest rates are falling and earnings are rising, growth stocks perform better. But when the economy starts to decline, growth stocks might be the first to fall. Value stocks often perform better during times of economic recovery. But when there are many years of a bull market (aka the stock market going up), they might lag behind growth stocks.

Value investing and growth investing are different strategies — Whether one or the other “works” or not will largely be determined by future market trends, which no one can reliably predict.

Historically, according to S&P Global, the company that runs the S&P 500, value stocks perform the best about half the time.

Between January 1995 and July 2019, value stocks performed better about 49% of the time, while growth stocks performed better about 51% of the time. That being said, investing doesn’t have to be a one or the other. Investing in a more diversified portfolio can give an investor the perks or both growth and value stocks.

The performance of the S&P 500, a stock index that tracks 500 large companies, is one of the primary metrics used when determining overall market performance.

The S&P 500 is a fairly even split between value and growth stocks — This is just a coincidence, as stocks aren’t specifically added based on whether they are growth or value. There are many broad-based indexes that focus on the total market. In addition it is common to find more granular indexes that further divide stocks into value and growth indexes.

Investors interested in value investing can take these initial steps:

1. Research. An important part of value investing is understanding the companies one might be investing in and understanding how to perform fundamental analysis of things like a company’s book value, price-to-earnings (P/E) ratio, etc.
2. Identifying undervalued companies. With an understanding of fundamental analysis, value investors look for companies that may be undervalued.
3. Buying and holding. Value investing generally involves a time horizon (meaning the amount of time you’ll hold the investment) of five years or more. While it might seem tempting to sell if the stock is performing particularly well (or particularly poorly), value investing generally involves buying and holding.