Do you like to check out the clearance rack when you go shopping? Are you always hunting for a good bargain? If that’s you, value investing might be a good strategy to adopt in your portfolio.
What is value investing exactly? Think of it as getting in early on something that’s heavily discounted. It’s an investment strategy where you can generate returns by investing in undervalued assets, like stocks and real estate. Value investors look for something in the stock market that has more value than it’s currently worth and invest in it. When more people catch on and demand rises, the stock price rises and your assets suddenly become more valuable.
This guide discusses what value investing is, how to identify stocks that are good value investments, and things to consider when using a value investing strategy in your portfolio.
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- Value investing is an investment strategy where you invest in undervalued stocks.
- You can choose the individual stocks yourself, or buy an ETF or mutual fund that has a value investing strategy.
- Value investors, such as Warren Buffett, study the financials of a company and look for stocks that are good long-term investments.
- Value investing requires patience, but can lead to large payoffs over a long time horizon.
What is value investing?
Value investing is similar to bargain shopping. Value investors look for stocks that are undervalued or are trading for less than what they are actually worth. Coca-Cola is a good example of a value stock.
Analysts at firms like Morningstar run financial models based on future performance expectations for undervalued companies. Their findings help value investors identify stocks that should be worth more and thus make good value stocks.
The goal of value investing is to get in on an undervalued stock early. Once more investors begin to catch on that a stock is undervalued they will flock to it. A surge in demand could lead the stock price to increase over time, netting value investors a handsome reward later on.
One of the most well-known value investors is Warren Buffett. One way he determines the value of a stock is by calculating its earnings yield, or the earnings per share divided by the share price. Yields make it possible to compare different types of assets and determine whether or not one is undervalued.
What makes a stock a “value stock”?
A stock can be considered a value stock if it has strong fundamentals. This includes things like positive cash flow, a revenue-generating business model, or profitability. By reading a company’s financial documents, it’s possible to understand how it makes money and whether or not it’s sustainable. For example, a business with excessive debt relative to its revenue may not qualify as a good value stock, while one with sound business operations might.
Stocks can be undervalued because of stock market psychology. Investors tend to invest based on emotions and the prevailing whims of the market. For example, when investors flocked to GameStop in 2021, it fueled a herd mentality among those eager to get in and earn a quick profit. When that happens, competing stocks can become undervalued, making them good value stocks.
Macroeconomic events can also determine whether or not a stock is undervalued. For example, a company working in higher education may be undervalued during a recession as investors leave the market to move to safer investments. As workers become displaced and go back to school, revenue increases, potentially making the stock more valuable.
Value investing is a holistic approach to the stock market. A company can be a value stock based on its business model and where it sits in the market. If it isn’t living up to its full potential, a value investor could seize the opportunity to swoop in and acquire shares for their portfolio.
Related: How to get started investing
How to find value stocks
To find value stocks, value investors hit the books. Warren Buffett spends five hours per day reading. This includes major newspapers and the financial statements of companies. While you might not have that much time to commit to studying value stocks, if you want to be a value investor, you’ll have to carve out some time doing the work to search for undervalued stocks.
Events in the news can be a good place to start. Bad press or a negative earnings report for a well-known company can make its competitors more appealing, creating an opportunity for their value to rise.
Less glamorous stocks can also be a good place to find value stocks. For example, Warren Buffett invests in companies like Coca-Cola and Kraft Heinz. While these stocks might not provide epic returns, like Amazon or Google, they are consumer staples that provide consistent revenue and have strong business models.
Related: What are ETFs?
Pros and cons of value investing
Before integrating a value investing strategy into your portfolio, there are some things you’ll want to consider, especially as it relates to your own risk tolerance and performance expectations.
Reduces the barrier to entry
Value investing makes it possible for new investors and investors without a large portfolio to get started with value stocks.
Large growth potential
Because value investors invest over the long term, there’s an opportunity to achieve a high reward on your investments. This can be from being an early investor in a stock or by reinvesting dividends from stocks like Coca-Cola and allowing growth to compound over time.
A simple strategy to implement
Unlike other strategies that require active trading, if you’re confident in your analysis of a company’s intrinsic value and plan to stay invested for a long period of time, value investing can be a good hands-off approach.
While anyone can get started in value investing, you still have to know what to look for. What you don’t pay for in dollars up front, you’ll pay for with your time studying the financial records of companies, looking for undervalued stocks to invest in.
Large price movements
Over time, a value stock can provide handsome rewards but that’s not to say it’ll be smooth sailing the entire time. There will be highs and lows as a company grows and adapts to changing economic headwinds. To get the most benefit, value investors need to be prepared to ride out the lows when they happen.
Putting all your eggs in one basket
Value investing might not be the best approach to creating a diversified investment portfolio. Coca-Cola and Kraft Heinz, for example, are two stocks Warren Buffett considers value stocks. Both are consumer food and beverage companies. Only investing in companies like that concentrates your investment within a specific industry, increasing your risk exposure.
Value vs. growth investing
Value investing can often get confused with growth investing. While the two investing strategies might appear similar, there are some important nuances to consider.
The biggest difference between a growth investor and a value investor is the emphasis on intrinsic value or the calculated value of a company after doing a fundamental analysis. Growth investors aren’t hitting the books like value investors.
Instead, growth investors are on the hunt for stocks that have the potential to grow rapidly. For example, thanks to greater consumer access to artificial intelligence, companies like NVIDIA are seeing explosive growth. Because AI is only just rolling out now, investors can expect companies like NVIDIA to continue to increase in value.
While growth investors are looking for high-growth stocks, there can be a lot more volatility and risk. The stock price might be higher in anticipation of higher returns, making it hard for new investors to get started. And if a company fails to deliver on expectations, it can lead to precipitous declines, hanging some growth investors out to dry.
The difference between value and growth investing strategies comes down to the alignment of a company’s reward risk and reward profile to your own investment goals.
Is Warren Buffett a value investor?
Warren Buffett is perhaps the best-known value investor out there. He studies the financial data of companies to look for ones that are undervalued. His strategy also includes quality businesses that might not be undervalued, but are a fair price compared to the value of the returns they provide.
Is value investing better than growth investing?
Determining which investing strategy is better comes down to your own personal goals. Growth stocks can provide high returns in a short period of time, but they come with greater risks. Identifying undervalued stocks upfront requires considerable effort, making value investing a demanding yet potentially rewarding long-term investment strategy.
Growth stocks, especially those in tech, have provided investors with great short-term returns but they don’t offer the same consistency to weather market volatility that value stocks might. Investors should leverage both types of strategies in alignment with their personal investing goals, expectations, and tolerance for risk.