You can't expect to avoid stock market downturns entirely. But value investors hope to keep their losses to a minimum -- and reap the rewards when the inevitable recovery comes.
When someone mentions value investing, your first thought may be of bottom-fishing bargain hunters who come in to scoop up fallen-angel stocks after they've gotten clipped by some market calamity. The popular impression is that they're the sort who started buying homebuilders like Toll Brothers
More than just bargain hunters
But value investing is far more complicated than just grabbing up stocks on the cheap. It's all about value -- separating attractive stocks from fallen stars that aren't likely to rise again to their former glory.
You'd think that bad market environments would be happy hunting grounds for value investors. Granted, when the markets irrationally start cutting prices on stocks regardless of their quality, that's good news for investors seeking good value. Yet amid the wreckage are a number of value traps -- low-priced stocks that appear to present tempting values but that, in fact, have problems that justify their declines.
Looking for safety
The key for a value investor is to find stocks that are already trading well below an objective assessment of the intrinsic value of the underlying business. When the stock market functions normally, it's tough to find bargains like this -- stock prices tend to reflect underlying value more closely.
Once in a while, however, problems like the one the markets face now -- like an overwhelming need for liquidity among financial institutions -- cause stock prices to retreat temporarily below reasonable objective value assessments. This represents an ideal time to buy because an investor gets both downside protection from further losses as well as heightened potential for profits.
On one hand, buying at a discount to intrinsic value protects your portfolio. If a stock like Burlington Northern Santa Fe
Furthermore, when markets become more rational, the discount provides a natural potential for profit. It's easy for a stock to rise much closer to your intrinsic value estimate -- giving you a quick 10% to 20% profit without any fundamental improvement in the stock.
Don't fall for stereotypes
If you're looking for value in the market, keep a few things in mind. First, while few people think of growth stocks like Apple
More importantly, remember that intrinsic value can change. What may look like a good value prospect can quickly become unattractive in a bad business environment. You may have to pull the plug on a potentially lucrative investment if the business doesn't go your way.
In the long run, however, value investors succeed by outlasting the negative sentiment of the market. If you have the fortitude and determination to go against the grain, value investing may be for you.
For more tips on understanding value investing, read about:
Read all about making money with value investing in our Motley Fool Inside Value newsletter. Learn from the greats of value investing and how you can find the world's best value stocks free with a 30-day trial subscription.
Fool contributor Dan Caplinger has dabbled in value investing from time to time. He doesn't own shares of the companies discussed in this article. Coca-Cola is an Inside Value recommendation. Apple is a Stock Advisor selection. The Fool's disclosure policy is a good value.