Value Investing Strategy 101: Important Things to Know

Last updated: July 19, 2020

If you are looking to invest in the stock market and are wondering which are the best value stocks to buy now, value investing strategy is something you need to familiarize yourself with. In this post, we are going to do just that. Let's get started.

Value Investing Strategy: All You Need to Know

What is Value Investing?

Value investing is an investment strategy that is focused on finding and investing in stocks that are undervalued and underappreciated by the stock market in general. The stocks that value investors seek typically look inexpensive compared to the underlying revenue and earnings from their businesses. Investors involved in the value investing strategy hope for a future increase in the stock price once other investors start appreciating the intrinsic value of the company's fundamental business.

A large difference between the intrinsic value and the current stock price signifies a greater margin of safety for value investors looking for investment opportunities. Since every value stock doesn't turn its business around successfully, that margin of safety is important for value investors to minimize their losses in the case that their assessment about the company turns out to be wrong.

What makes a great value stock?

The primary and most definitive characteristic of a value stock is its inexpensive valuation compared to the value of its assets or its key financial metrics (such as revenue, earnings, or cash flow). These are some other key characteristics of a great value stock:

  • Well-established businesses with long histories of success
  • Consistent profitability
  • Stable revenue streams, without huge amounts of growth but typically also without big contractions in sales either
  • Dividend payments, although paying a dividend isn't a requirement to qualify as a value stock

However, just because a company has these attributes, it doesn't automatically make it a great value stock. Sometimes, a stock only appears to be a good value for investors but is actually a value trap. Value traps can continue to suffer share price declines even when their stocks seem attractive.

Why should you invest in value stocks?

Everyone likes a bargain, and because value investing seeks stocks selling at a discount to their intrinsic value, the investment strategy appeals to those who like to get good deals. All it takes to make money with a value stock is for enough other investors to realize that there's a mismatch between the stock's current price and what it's actually worth. Once that happens, the share price should go up to reflect the higher intrinsic value. Then those who bought in at a discount will get their profit.

Furthermore, many investors like the margin of safety provided by a stock that's purchased for less than what it's inherently worth. There's no guarantee that the stock price won't fall further, but it does make additional share-price declines less probable and less dramatic.

For those who see themselves as defensive investors without much tolerance for risk, a good value stock can provide both protection against losing money and the potential to cash in after the stock market has recognized the true value of the stock.

Value investing can require patience, because it often takes a long time for a value stock to get repriced at a more appropriate higher level. For those willing to wait, however, the returns can be quite sizable.

How to look for value stocks?

Value investing requires a lot of research. You'll have to do your homework, going through many out-of-favor stocks to measure a company's intrinsic value and compare it to its current stock price. Often, you'll have to look at dozens of companies before you find a single one that's a true value stock.

That's enough to intimidate many would-be value investors, but there are some tricks you can use to identify good value stocks. By fully understanding the many ways to value a company and assess its business prospects, you can weed out inappropriate stocks more quickly to concentrate on your best candidates.

How to avoid value traps?

A value trap is a stock that appears cheap but actually is not. Value traps are usually created in these scenarios:

  • Stocks in cyclical industries like manufacturing and construction often see their earnings rise substantially during boom times, only to see much of those earnings disappear when industry conditions cool off. When investors see a possible bust coming for a stock, its valuation will look very inexpensive compared to recent earnings -- but much less so once earnings fall during the weaker part of the business cycle.
  • Stocks in areas that emphasize intellectual property are prone to become value traps. For instance, if a drug company has a high-selling treatment but is losing patent protection for it in the near future, then much of its profits can disappear quickly. The same is true of a tech company that's the first mover in a new industry but that lacks the ability to protect itself against the competition.

Always remember, a company's future is far more important than its past, especially when it comes to valuing a stock. The true value of a stock can be found by analyzing a company's sales prospects and earnings growth. It will also help you avoid the dreaded value traps.