Value investing is simple in concept, but complex in practice. In simple terms, investors employing a value investing strategy look to buy stocks which are currently undervalued by the market, according to some form of analysis they employ.
How does value investing work?
The key to value investing is investing when you believe an asset is undervalued. This means that value investors need to employ different metrics and make calculations to determine what they consider to be the true worth of an asset.
These metrics might include:
Once an investor has used these to come up with their own picture of an asset’s value, they can compare it to the going price for a slice of the pie. If the price is cheap against their own estimation, a value investor might jump at the chance.
When deciding whether to act, value investors will look at the ‘margin of safety’.
Warren Buffett himself once said: “The three most important words in investing… margin of safety”.
But what is it?
This is essentially the difference between the current price of the asset and what an investor has determined to be the asset’s true value. In other words, a higher margin of safety indicates more room for a share price to increase and thus for an investor to make more money.
Now that we’ve outlined the basics, let’s look at when value investors can pounce.
Opportunities for value investing
Opportunities can come in many different shapes and sizes.
For example, a company’s share price may be knocked lower by a piece of bad news, even though all else indicates that the company’s worth is little changed.
It’s worth noting that the practice of value investing also includes the belief that investors will generally overreact to good or bad news, leading them to buy or sell stock without properly considering a company’s long-term financial prospects.
These scenarios are among the easiest to spot, as a company’s share price can drop sharply on the back of just a couple of negative news stories.
However, other opportunities exist as well.
One worth noting is that some stocks are simply sexier than others. Big flashy tech stocks like Apple (NASDAQ: AAPL) or companies with popular CEOs like Tesla’s (NASDAQ: TSLA) Elon Musk are more likely to be attractive to investors and therefore have a price that might exceed the company’s actual worth.
On the other hand, less glamorous stocks like utilities or consumer staples might be flying under the radar. As such, great opportunities can emerge here with very few investors taking notice.
Value investing or growth investing?
Value investing is one of the two main investment strategies, alongside growth investing. While value investing focuses on undervalued stocks, growth investing is concerned with stocks which offer strong earnings growth and are therefore expected to increase in value over time.
This largely means that growth and value strategies target completely different stocks. Growth stocks are often priced higher than their financial fundamentals indicate they are worth, with their value stemming from their future promise.
As such, these stocks are unlikely to be undervalued and will therefore be unappealing to investors prioritising a value investing strategy.
However, the two strategies do not have to be practised in isolation from one another.
Some investors utilise blended portfolios, which are comprised of a mixture of value and growth stocks. This diversification nullifies much of the risk of sticking with one specific strategy.