The Value Investing Strategy

The challenge for the value investor is to distinguish between stocks priced low for a reason versus those that are true bargains. This typically requires analyzing the company's business model and estimating its intrinsic value. Popular valuation methods include discounted cash-flow analysis and peer comparisons on key ratios, such as the price-to-earnings (P/E) ratio, price-to-sales (P/S) ratio, and price-to-book value (P/B) ratio.

Truly undervalued companies usually take time to realize their potential. That adds uncertainty to the process since time can introduce new and unfavorable circumstances. Value investors address the uncertainty in two ways:

1. Maintaining a long-term outlook. Holding periods for value companies should be long or even indefinite. Value investors look to achieve gains through compounding appreciation over years and decades. This requires the patience to resist selling off during market downturns.
2. Incorporating a margin of safety. The margin of safety is the difference between the company's fair value per share and its current stock price, expressed as a percentage. If a stock is worth $100 and is trading for $80, the margin of safety is 20%. A high margin of safety -- say, 30% -- implies lower downside risk and higher upside potential for the value investor.

What makes a great value stock?

The defining characteristic of a value stock is a low price relative to the company's fair value per share. However, the best value stocks often have other attractive qualities, such as:

• A proven business model
• A long track record of profitability during both strong and weak economies
• Steady growth in revenue and cash flow
• Experienced leadership
• Low leverage
• A strong competitive advantage, such as brand loyalty
• Commitment to returning value to shareholders through share buybacks and/or dividend payments

Why invest in value stocks?

Value investing is often compared to growth investing, which involves buying companies that could potentially grow much faster than the market or their peers. While the two strategies are not mutually exclusive, value investing can deliver more stable returns with less volatility relative to growth investing. Growth stocks can rise quickly but fall just as fast.

Value stocks appeal to investors who:

1. Don't trade heavily
2. Prefer lower volatility
3. Are willing to buy when other investors are selling
4. Enjoy research and analysis
5. Appreciate regular dividend income

For those who view themselves as defensive investors without much tolerance for risk, a good value stock can protect against losses while offering a reasonable potential for gains.

How to find value stocks

Value investors often begin their search with a stock screener. Stock screeners return a list of public companies that meet set criteria, such as:

1. Maximum P/E ratio. P/E ratios vary dramatically by industry, but many value investors like to see this number below 15 or 20.
2. Maximum P/B ratio. A P/B ratio below 1 can indicate the company is undervalued, but this number should not be analyzed in isolation. A low P/B ratio could also result from a fundamental problem with the business.
3. Minimum ROE. Return on equity (ROE) indicates how well the company produces returns from its net assets. This metric is also industry-dependent, with higher values indicating better performance.
4. Minimum dividend yield. Dividends provide some certainty in returns. The minimum dividend yield an investor requires is a personal decision. Often, value investors will target a range of yields that is higher than the average market yield but not so high as to be unsustainable.
5. Five-year EPS growth outlook. Value stocks that are expected to grow their earnings per share (EPS) are more likely to gain investors' attention and support.
6. PEG ratio. The price-to-earnings-to-growth (PEG) ratio is calculated by dividing the stock's P/E ratio by its expected EPS growth rate. Near or less than 1 is a preferred value here.

Once you have a list of stocks that meet your value criteria, the real work begins. You then review each to estimate intrinsic value and compare those intrinsic values to current stock prices. You may have to repeat this process dozens of times before you find a stock that meets your desired margin of safety threshold.

Avoiding value traps

A value trap is a stock that looks cheap on the surface but is priced fairly, given the company's ability to create value. Here are two situations to watch for:

1. Stocks in cyclical industries such as manufacturing and construction. These companies may see their earnings rise substantially during boom times and then fall dramatically when industry conditions cool off. When investors anticipate a possible bust for a stock, its valuation will look very inexpensive compared to recent earnings -- but less so once earnings fall during the weaker part of the business cycle.
2. Stocks that rely on intellectual property can become value traps. Consider a drug company with a dominant, high-selling treatment that's patent-protected. When patent protections expire, the drug producer will see revenue and earnings dip unless there are promising replacements in the pipeline. The same can happen for a tech company that's the first mover in a new industry but lacks the ability to innovate further.

Value traps have weak growth outlooks in the short or intermediate term. To avoid them, include a review of EPS outlooks and PEG ratios in your analyses. These items address the company's future, while other valuation metrics, such as the standard P/E ratio, only measure the company's past performance.

Is value investing right for you?

If your primary investing goal is to keep your risk of permanent losses low while increasing your odds of generating positive returns, you may be a value investor at heart. Know that value investing requires resilience. The value-finding process eliminates far more stocks than it uncovers, and this can be frustrating, particularly during bull markets.

Many stocks you eliminate during your search will appreciate in bull markets, even though you found them too expensive at the start. The payback comes when the bull market ends. That's when your margin of safety protects you from the most extreme value losses. The dividend income you earn from value stocks also encourages you to stay invested through downturns, keeping you in contention for recovery gains.

By contrast, if you prefer trading the hottest companies in the market, you may be bored by value investing. Value stocks are not trendy. They may not even be interesting in terms of their business model.