Value investing is a popular investing strategy made famous by a number of successful and well-known investors, including investing icon Warren Buffet. Value investing involves identifying and purchasing stocks that are trading at prices below their intrinsic value.1
Value investing can offer the potential for very solid returns over time, but it can have its pitfalls.
Value versus price
When we talk about value investing, it’s important to talk about the difference between price and value.
A stock’s price is just that: what you would pay to buy or sell the stock. Although we believe that, in the long run, as Warren Buffet has said, the stock market is a weighing machine that generally reflects the value the company has created, in the short run it is, to use his term, a "voting machine" reflecting the immediate sentiment of investors. That immediate sentiment might be based on everything from company news to macro developments to mysterious movements just because.
Value, on the other hand, captures something else: what an analyst believes the company is worth based on its business; financial metrics like free cash flow, price-to-book, and price-to-earnings; and future prospects. While there are different methods of calculating intrinsic value, like discounted cash flows, dividend discount models, and others, they all aim to arrive at a number that reflects the underlying value of the company and, thus, the stock.
Value investing capitalizes on the difference between those two numbers.
Efficient markets
The biggest challenge to value investing is market efficiency. "Efficient markets" is the theory that asset prices reflect all available knowledge, thereby pricing in things like future cash flows.
While prices can move based on all kinds of elements, the ubiquity and wide availability of information does make it harder to find a stock that is truly undervalued.
Value traps
A value trap is a stock that might look like a bargain at first blush, but upon detailed analysis proves to be fairly or overvalued.
For example, a stock might look like a solid value investment due to the fact that it’s trading at a low price-to-earnings ratio (PE) or perhaps a low price-to-book ratio (PB). It might look undervalued because future prospects have been hyped up.
While metrics are important, investors need to look beyond them to what’s actually happening within the company.
- Are the company’s profits inconsistent over time? This can be a sign of management struggles within the company.
- Does the company have issues with cost management? A company that cannot keep its costs in line over time could face major profitability issues over time.
- Poor management. A company may look attractively priced, but this may be due to poor management decisions keeping the stock price low. Over time, a poorly-managed company can run into all sorts of problems that can keep its share price low over time.
Research can take time
Successful value investing with individual stocks can entail time consuming research. This includes research into a prospective company’s financial statements, trends within the company’s industry, and other factors impacting both the company and its industry.
It's important to monitor companies that you are considering adding to your portfolio. Do they continue to fit into a value mode that would be appropriate for your portfolio? Has the stock price appreciated greatly, moving them out of consideration as a value investment for you?
The risk of making assumptions
All methods of calculating intrinsic value rely on assumptions: how much the investor expects the company to grow, what the market will look like, how interest rates will behave, and more.
If an investor is overly optimistic, or if the landscape changes dramatically, the assumptions may not pan out, making what might have been a value play a loss.
Time and patience
While all investing requires patience, value investing can require more patience than many other strategies.
It can take years or even several decades for the stock market to recognize the value that your analysis has revealed for the shares. After a few years of little or no price appreciation, it can be tempting to sell the shares thinking the investment had been a mistake.
Waiting can be stressful. Before making an investment of this type be sure that you can handle the stress that can come with the need for time to pass until the investment hopefully pans out.
Missed opportunities
Investing in a value stock, especially a deep value stock that might take many years to pan out, can cause you to miss other potentially profitable investment opportunities.
It can be frustrating to see shares of other companies that you might have invested in appreciate in value while you hold onto a value investment that has yet to realize its potential. This is something that you need to think through before investing in value stocks.
Underperformance in bull markets
A significant downside of value investing is the potential for significant underperformance of deep value stocks during a bull market. Even though the markets as a whole have historically over time been rising, these value stocks can often lag.2 Value stocks are rarely in high-growth industries like technology or consumer discretionary that drive the market higher.
Often the portion of your portfolio that is devoted to these deep value stocks will lag during a market rally. If you are considering adding deep value stocks to your portfolio, it is important that you understand that these stocks may lag the markets in the short term, and that you commit to being patient.
Stress and second-guessing yourself
No matter how well you’ve researched a value stock, short-term underperformance can cause stress and result in second-guessing your investing decision. It's important to understand these feelings and to be able to reconcile that this may happen over time.
Value investing with individual stocks takes discipline and commitment. It's important to make sure that you can deal with the stress and potential self-doubt that can be a part of the value investing process.
Final thoughts
An allocation to value stocks can be part of a sound asset allocation plan, but it’s important to understand both the upside potential in these types of investments as well as the potential pitfalls. All investing involves risk and may lose money. Value investing can be lucrative, but it’s not without its risks.
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