What Is Value Investing? And Is It Right For You?
Value investing has made many investors a lot of money, however, it has also caused many to lose their investment capital. But what is value investing? And is it right for you? Here are some of the risks and benefits you should consider before adopting this strategy.
What Is Value Investing?
Value investing is an investment strategy for long-term investors focused on picking individual undervalued stocks. These stocks are then held for the long term and eventually sold at a higher value.
Value investing is stock picking based on facts, principles, and research. It attempts to remove all emotion and subjectivity from trading equities.
Value investors perform active research to determine the value of a stock based on the company’s long-term fundamentals.
There is a belief among value investors that share prices react to news and media (both good and bad). And that these stock market fluctuations may not necessarily correlate to a company’s long-term fundamentals and growth potential.
So when that stock goes “on-sale” or is trading for a lower price, then the value investor may look to add it to their portfolio, eventually selling it when the price is right.
Well-Known Value Investors
Some of the most well-known value investors are Warren Buffet and Charlie Munger of Berkshire Hathaway.
Benjamin Graham is said to be the godfather of value investing and was a mentor to Warren Buffet. He wrote a book called The Intelligent Investor, and it is a great place to learn more if you’re ready to try this strategy.
Benefits of Value Investing
Value investing can be a very lucrative investment strategy if you’re willing to put in the time to do the research. Here are some benefits of value investing strategies.
One of the main benefits of value investing is that it relies on a systematic strategy to remove emotions from trading equities. This can help to decrease the speculation involved when investing in individual companies.
By focusing on the system and sticking to your strategy, the daily ups and downs of the market will have less influence on you.
Based on Fundamentals
Similar to the systematic value investing strategy, this way of investing relies on the company’s long-term fundamentals.
Value investors can take advantage of short-term market fluctuations because they have confidence in a company’s long-term growth potential. This confidence comes from the facts and figures of the company’s financial statements, not emotions.
Margin of Safety
One of the keys to buying a value stock is to make sure there is always a margin of safety. You can think of this margin of safety as a buffer for errors. The larger the difference in the trading stock price and intrinsic value, the greater the margin for safety.
The margin of safety is essential when buying value shares because there is always a chance that calculations or figures can be off slightly. For example, would you rather purchase something that is 10% off or 50% off?
Long-Term Capital Gains
Value investing is a long-term investment strategy. Stocks are bought and held for an extended period(usually greater than one year) before they are sold or traded.
The profits on stocks held for more than a year are subject to long-term capital gains tax. This tax rate is much more favourable than the short-term capital gains tax rate.
If you buy and then sell stock in less than a year, you will be subject to short-term capital gains. This means more money for the government and less money for you.
Potential For Greater Returns
Because you are buying individual stocks with value investing, there is a potential for greater returns than buying index funds or broad-based exchange-traded funders (ETFs).
If you do your research and can identify strong value stocks and purchase them on sale, all you have to do is wait. Eventually, the long-term fundamentals of that company should kick in raising the share price and netting you a nice profit.
But with this greater potential for returns comes a greater risk of loss as well.
Risks of Value Investing
If you are contemplating becoming a value investor, you may want to consider the risks first.
Risk of Loss
Even though there is a lot of research behind picking a value stock, there is always the chance you get something wrong. There is also a chance that the markets do not perform as expected, or the company experiences a black swan event.
In these cases, because you invest in an individual stock, there is the chance that you could lose your entire investment.
The research and fundamentals will help to decrease this risk but can’t eliminate it.
Active Research Required
When you’re just starting, picking value stocks can come with a steep learning curve. However, there is a lot of information to learn and review before you’re ready to start trading stocks.
And that’s just the beginning. There is also active research required throughout your investment in a stock. For example, you will want to make sure that you track the market to know when to sell or when to buy more.
If you don’t have the time to keep up with the research, your portfolio could be at risk.
Ability to Read and Analyze Financial Statements
Picking value stocks relies on your ability to read and analyze a company’s financial statements and reports. There is a large amount of trust that goes into these numbers. And you have to know what you’re doing.
If the company doesn’t report everything accurately or reports things differently than you are used to, there is an increased risk that you will pick the wrong stock.
There is more than one way to determine a company’s financial ratios, healthy and long-term fundamentals. Unfortunately, this can make comparing two companies difficult.
There are different opinions as to what diversification means when value investing. But if you’re only investing in one industry, you are probably not diversified.
And with a lack of diversification comes a more significant risk to your portfolio if something negatively affects that industry.
Humans are not robots. As much as we may try to take emotion out of our investments, it is bound to creep in from time to time. Not keeping your emotions in check can significantly impact the outcome of your investment portfolio and not always in a good way.
What Are Value Stocks?
Value stocks are picked based on their trading value being less than their intrinsic value. After a research period, investors determine if a stock is a value stock based on various criteria.
One of the main criteria for a value stock is a stock that is undervalued based on the company’s long-term fundamentals. Several different reasons can cause this undervaluation, including an inefficient stock market.
Value stocks are different from income and growth investing.
Is Value Investing Right for You?
Value investing is a good investment strategy for you if you:
- Have an interest in researching stocks
- Can ignore your emotions when investing
- Are investing for the long term
- Have the time to do the required research
- Are willing to learn the systematic strategy
If you don’t fit the criteria above, you may consider some alternatives to value investing.
Alternatives to Value Investing
The risk of value investing may be too much for some to stomach. If this is you, here are a few alternative strategies you may consider:
- Dividend investing – investing in stocks with solid dividend yields
- Index or ETF investing – investing in broad-based index funds that represent large portions (if not all) of the stock market
- Robo-advisors – using a computer algorithm to invest (according to your risk tolerance) and automatically rebalance your portfolio.