What is a Value Stock or Fund?
What sets value stocks apart from their counterparts is the fundamental principle of purchasing at a discount. Value investors aim to identify stocks trading at a lower price relative to their intrinsic value, believing that the market has undervalued them. This approach involves assessing a company's financial health, analyzing its assets, earnings, and potential for growth, among other factors. By focusing on the underlying value rather than short-term market fluctuations, value investors seek to obtain long-term gains from holding good companies until their true value is realized.
This article reviews why value stocks are important, where value fits into a portfolio, and how to find a value stock.
Why Value Stocks are Important
The two ways to make money in stock investments are to either receive dividends or to sell your stock for more than you bought it for. Investing for dividends is not the subject of this article, but the important thing to understand about dividends is that they can help offset losses or add to any gains the stock price has made. The historic dividend rate has been falling since the 1990s, making the price you sell a stock more important.
A History of the S&P 500 Dividend Yield (investopedia.com)
How do you increase the chances you can sell a stock for more than you bought it for? Buy it for less than it’s worth (aka value investing). Think of it like going to the grocery store and seeing a “Buy 2, Get 3 Free” deal on ice cream. Who doesn’t like getting five cartons of ice cream for the price of 2?
A Value Stock is merely a stock you can buy for a deal. Value investing is the systematic identification and investment in value stocks.
A large body of investment research has been published surrounding the historical significance of value investing. Warren Buffett, Benjamin Graham, Howard Marks, and Joel Greenblatt have also had long and very profitable investment careers out of executing this strategy. Investment management companies often feature value funds in their lineups, and some, like Dimensional Funds, focus on it almost entirely.
The below chart (published by Dimensional Funds) shows the year-by-year difference in returns between value stocks and growth stocks – a common comparison. While value investing does not outperform every year, the strategy should warrant consideration given its long track record of providing returns for investors.
Past performance is no guarantee of future results. Investing risks include loss of principal and fluctuating value. There is no guarantee an investment strategy will be successful. The Fama/French Indices represent academic concepts that may be used in portfolio construction and are not available for direct investment or for use as a benchmark. Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment.
Chart in US dollars. Yearly premiums are calculated as the difference in one-year returns between the two indices described. Value minus growth: Fama/French US Value Research Index minus the Fama/French US Growth Research Index.
Fama/French US Value Research Index: Provided by Fama/French from CRSP securities data. Includes the lower 30% in price-to-book of NYSE securities (plus NYSE Amex equivalents since July 1962 and Nasdaq equivalents since 1973).
Fama/French US Growth Research Index: Provided by Fama/French from CRSP securities data. Includes the higher 30% in price-to-book of NYSE securities (plus NYSE Amex equivalents since July 1962 and Nasdaq equivalents since 1973)
Source: When It’s Value vs. Growth, History Is on Value’s Side | Dimensional
A Simple Example of a Value and Growth Stock
Consider this simple example. Let’s assume you are looking to buy a company. You have two choices:
Company A is a more established company with a strong balance sheet (high assets and low debts) and a steady income stream with a modest growth rate. Company A makes $50,000 per year in profits growing at 4% per year, just above the inflation rate. You can buy Company A for $500,000.
Company B is a newer company in a new area of the economy. While it has assets, it is also highly leveraged with debt that helped get the business up and running. The company has recently begun returning a profit of $25,000, and its revenues are growing at a rate of 20% per year. Because of its growth prospects, Company B is up for sale for $1,500,000.
See the Company Financial box below for these numbers.
Company A is a classic example of a value stock. The Price per Earnings for this company is 10x which means you are paying $10 for every $1 of earnings the company has each year. You are also paying $500,000 for a company worth $450,000 in book value (assets minus liabilities). Because Company A has a more predictable income and high book value, it will be easier to have a return on your investment.
Company B is a classic example of a growth stock. The Price Per Earnings for this company is 60x which means you are paying $60 for every $1 of earnings. Additionally, you are paying $500,000 for only $50,000 of company book value. Why would you do this? The key to growth stock success is the achievement of the growth rate. IF they achieve the estimated 20% growth rate, Company B’s income would match Company A’s in 5 years and more than double it in 10 years. The risk of Company B comes in the “IF they achieve.”
Value Stocks Place in the Investment World
The investing world loves to come up with new terms to describe a type of investment strategy. As human beings, we also love to be able to a thing into a specific category, whether it deserves to be there or not, because it helps us navigate the complexities of the stock markets.
One of the most popular methods of splitting up the stock market is Morningstar’s Style Box, as shown below. Most investment software today provides some sort of classification like this, and many simply use the data directly from Morningstar.
The box is broken down into nine quadrants specifying investment style (Value, Blend, Growth) and Company Size (Large, Mid, Small). Value stocks are considered less risky as you buy them at reasonable prices, and their returns are less dependent on the achievement of future growth, which is never guaranteed, as shown in the simple example above.
It’s important to recognize that no investment strategy works 100% of the time. That is where good diversification comes into play in your portfolio. Not investing in different areas of the market increases your risk of not owning the area of the market, driving returns.
How do you find a value stock?
- Do your own research: You could do your own research into companies to identify those that might be considered value stocks. This involves knowledge of the companies financials, growth prospects, sector trends, company management, and more. Fully understanding a company’s business model and intrinsic value takes time and expertise that few investors exhibit.
- Invest in Active Investment Managers: Purchasing a mutual funds, exchange traded fund, or other investment where a professional investment manager is selecting which positions should be included is another way to gain access to value stocks. The managers who have expertise in analyzing company financials and access to investment analysis resources perform the due diligence in selecting which funds they consider to be value. Generally, active managers select the candidates they hold the highest conviction for and hold fewer positions over time.
- Invest in Passive Investment Strategies: In contract to active managers, passive investments simply categorize companies based on a set number of metrics. Rather than focusing on just a few stocks with high conviction, these funds buy are larger number of stocks that fit their criteria.
The most common metrics used in index screening for value stocks are:
- Price-to-Earnings (Projected): The price you pay for every dollar of future expected earnings.
- Price-to-Earnings (Historic): The price you pay for every dollar of recent historic earnings.
- Price-to-Book: The price you pay for the book value of the company.
- Price-to-Sales: The price you pay for every dollar of Gross Income the company has.
- Price-to-Cashflow: The price you pay for every dollar of free cash flow the company has.
- Dividend Yield: The amount of dividends paid divided by the company price.
These metrics are applied across the stocks in the chosen index stock pool. Companies with the highest ratings are eligible for inclusion the fund line up. Different index funds use different combinations of the above metrics and weight their importance differently to come up with their selections.
Summary
Value investing is a compelling investment strategy that can offer long-term returns for investors who stay the course. While it should not be the only investment strategy to consider, it’s long history and focus on fundamentals make it a valuable consideration for any diversified portfolio.