How To Be a Value Investor

There are two general types of investors: Growth investors and value investors. Here, we explore the benefits of being a value investor, and how to find success using this method.

The Long-Term Value in Value Investing

Value investing is a strategy that involves buying stocks that are cheap relative to their intrinsic value or some other fundamental measure, such as earnings, revenue, cash-flow or book value. Value stocks typically have low investor expectations and trade at a discount due to concerns about the future of their business. Those investing in value stocks are hoping for an improvement in the underlying fundamentals, which could eventually produce better performance.

Value stocks have generated a premium above the market’s return over the long run, according to academic studies, with small cap value stocks delivering the largest premium. A significant driver of the return of value stocks comes early in economic expansions and bull markets. This is for two reasons: First, they are often the stocks that get hit the hardest in a bear market, and secondly, value stocks tend to be cyclical and see earnings increases at the beginning of expansions.

“The secret to investing is to figure out the value of something – and then pay a lot less.”

This quote from Joel Greenblatt, famous value investor, author and academic, captures the essence of value investing, which continues to evolve over time.

From Graham to Buffett and Beyond with Value Investing

Value investing has evolved over time. The concept was first espoused by Benjamin Graham, who is known as the Father of Value Investing. His books, including The Intelligent Investor, offer foundational concepts for value investors. He advocated thinking of stock ownership as a business owner would, buying stocks that are cheap, maintaining a long-term view and a controlled temperament and seeking a “margin of safety” when buying value stocks. These concepts still ring true today.

Warren Buffett, perhaps the greatest investor of all time, was Graham’s student at Columbia Business School. Early in his career, he was a deep, concentrated value investor. His approach has shifted over the years to buying high quality businesses and trying to acquire them at a discount, but valuation remains an important part of his process.

Value investing has evolved over the past 100 years, starting with finding stocks that trade at or near book value, to buying high quality companies that trade at reasonable prices, to buying companies that have the ability to grow into their valuations, such as the leading technology names today that were attractive values just five to 10 years ago even though they didn’t seem "cheap" at the time.

No matter which way you define value investing, the idea of buying something today for less than its true value will always remain a winning investment strategy.

The Reasons Why Value Investing Works

Value investing has shown the ability to work over time, but understanding the “why” behind the premium in value stocks is worth spending a moment on. There are two key explanations:

• The Risk-based Explanation: This argues that value stocks deliver outperformance because they are riskier than other stocks. While some investors relate value to more conservative companies, the opposite is often true for value stocks, particularly during times of financial stress. Since many value stocks are companies with businesses that are uncertain or in decline, they can be hit extra hard during economic slowdowns and recessions. Coming out of recessionary periods, the value stock cohort often exhibits excess returns over the market. This evidence would point to value stocks exhibiting more, not less, risk.
• The Behavioral-based Explanation: This argues that investors both under and overreact to both good and bad news. For value stocks, which typically have some uncertainty around their future prospects, the behavioral-based explanation says that investors, as a group, become too pessimistic about a company’s problems and push the stock’s valuation down too far. As business improves, even by the slightest margin, stocks tend to revert as investors realize things aren’t as bad as they appeared.

The reality is that the answer to why value investing strategy works is somewhere in the middle between risk and investor behavior, but both offer explanations as to why the value premium is likely to persist in the future.

Finding Cheap Stocks Using Multiple Value Metrics

Here are some of the most common value investing ratios (we put them into practice with a list of the current cheapest stocks using a composite of all of them in the table below).

• Price/Earnings (P/E): This is a ratio of price per share relative to earnings per share. Stocks with low P/E ratios may be considered value stocks and as the profits for these companies improve, albeit slightly, the price of the stock should follow.

P/E = stock price per share / earnings per share

• Price/Sales (P/S): This ratio looks at price per share relative to sales per share. Sales are less susceptible to adjustments and account gimmicky as compared to earnings. A low P/S ratio indicates an attractive value when compared to peers.

P/S = stock price per share / sales per share

• Price/Book (P/B): This ratio looks at price per share relative to book value per share. Investors using the P/B ratio are looking to buy stocks that look cheap based on their value of a company’s assets on its balance sheet.

P/B = stock price per share / book value per share

• Price/Cash Flow (P/CF): This ratio looks at price per share relative to cash flow per share. Some investors prefer using cash flow since it is more difficult to manipulate than earnings.

P/CF = stock price per share / cash flow per share

• Enterprise Value/Earnings Before Interest Taxes Depreciation and Amortization (EBITDA): This ratio looks at a firm’s enterprise value, which is its market capitalization plus debt minus cash on hand and it relative to EBITDA (EV=MC+Total Debt−C). This measure attempts to look at a business in the way an acquiring company would if purchasing the entire business in a private transaction.

In all instances, the lower the valuation ratio, the more the stock exhibits value.

See the Top Scoring Value Stocks in Today’s Market

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