At its crux, value investing is the practice of identifying high-performing stocks whose price point is low compared to the value they offer investors, especially if that value is forecasted to grow significantly over the long-term. One of the reasons this form of investing has been able to maintain such a solid reputation and stronghold is due to the fact that there are so many flash-in-the-pan products produced by trendy companies that traditional investors clamor over initially. While the startup fever is high, it can be nearly impossible to guarantee that such growth stocks will generate substantial returns down the road, when the smoke and initial buzz clear.
On the other hand, value investors make it a practice to invest in decidedly unglamorous stocks that, while they might not always carry the prestige and name recognition of others, have been solid performers on the market and are reliable bets for steady growth. These are stocks that have weathered the ebbs and flows of the market and have still maintained an uptick toward profitability. If you’re just getting your feet wet in the value investing sphere, here are three practices to implement that can help you come out on top, even amid shaky market conditions.
Lead with market price. Remember, the goal as a value investor is to obtain shares of undervalued stock that you believe will eventually rise. As such, while you might find several high-priced value stocks in your search, it’s not guaranteed that these will all maintain their current level of popularity. On the contrary, if the shares are priced so high that the market price exceeds their intrinsic value (the price you’re willing to pay for it, everything considered), then demand will eventually drop, along with the dollar sign. The space between a stock’s intrinsic value and its market price should be as large as possible, to allow room for maximum growth.
So, analyze a stock’s market price first, then consider its intrinsic value. If a share is already marked at an exorbitant price, there’s only one way to go from there, and it’s not a comfortable situation for a value investor to be in.
Utilize industry metrics. Value investors measure a share’s worth by several means, but one of the most common is the Price to Earnings (P/E) ratio. In essence, this is the practice of dividing the price of the share by the company’s overall earnings per share.
Experts recommend focusing on shares that carry a P/E ratio of less than 20, though keep in mind that no two are the same and that there are multiple ways to value a stock. Another tactic to try is calculating its Price/Earnings-Growth (PEG) ratio, which takes the P/E figure and divides it by the anticipated earnings growth rate. You can also take a look at price-to-book ratios, price-to-cash flow ratio, and even peer comparisons to get a feel for how the stock is priced and performing compared to other, similar companies in its industry.
While performing this research, it’s also important to understand which classes of stocks might appear to be value stocks, but actually lack the growth potential that others can present. For instance, stocks within some real estate investment trusts, or that fall into a tightly regulated industry such as utilities, are likely controlled to a high extent and as such, won’t be as mobile as a true value stock would be.
Exercise patience. The core of value investing is patience, as it may take some time for an undervalued stock to reveal its true worth. Moreover, value investing is only a part of a diversified investment portfolio and should be considered against the wider backdrop of a long-term strategy. Any major financial decision, from refinancing your home to saving for retirement, should be entered into with a general timeline in mind. Along the same lines, there’s a projected schedule to the value investing process and it may be longer than first expected. That’s because though the degree of risk is higher with growth stocks than value stocks, there could still be bumps along the road. The difference for value investors is that once those bumps smooth out, the value stocks you took a risk on in the beginning should still come out on top, while more trendy options might have fallen by the wayside. Thus, many value investors utilize index funds, which blend both value and growth investments, to create a more balanced mix of risk and reward.
As with any equity holding, staying flexible, patient, and knowledgeable throughout the value investing process is key. Keeping these three steps in mind, even the most uninitiated investors can be on their way toward building a strong and successful portfolio that stands the test of time.