Value investors, often referred to as Contrarian Investors, are always on the lookout for underpriced stocks. This is a research-intensive strategy, in order to excel you will need to get very good at interpreting a company's financial statements, financial metrics and statistical measures. Value Investors use analysis to determine whether a company is trading above or below its fair value and they only buy when they find a strong company that they believe is undervalued. Undervalued is a term that you'll hear value investors use a lot because identifying and buying undervalued stocks is the cornerstone of the strategy.
Value investors don't care much about the short-term behavior of the market unless there is so much volatility that new undervalued stocks are emerging. They spend the majority of their time researching companies and very little time or effort trying to keep up with the market. The theory is that the market will go up over long periods of time regardless, so rather than wasting time worrying about what the market will do, they put their efforts into finding great underpriced companies that will outperform. The S&P 500 has averaged a 10% return per year since inception so the theory is a pretty strong one.
This is definitely a buy-and-hold strategy, you cannot be a value investor if you bounce in and out of investments frequently. When you find an undervalued company, you will often have to sit on it for years while you wait for the market to realize the true value of the stock. Any strategy that requires that you hold investments for long periods of time makes it that much more important to master the strategy's stock selection criteria. As a value investor, you must be able to distinguish between companies that are underpriced for a legitimate reason (decreasing profit margins, losing market share, or losing out to competitors to name a few) and those that are healthy companies with strong long-term prospects and are simply trading below their fair market value.
Investment Selection Methods
Successful Value Investors do exhaustive research on a company before they buy the stock, and their particular type of research is called fundamental analysis. Most value investors agree that you can never know too much about an investment. Fundamental analysis is a good fit with this strategy because, if done thoroughly, it will provide a very comprehensive view of the present condition and future prospects of a company.
Several other strategies require at least rudimentary fundamental analysis to make sure that there is nothing glaringly bad about an investment, but Value Investors take their analysis several steps further. They dig deep into the balance sheet, financial statements, and cash flow statements because they want to have a clear picture of the assets, liabilities, revenues and expenses. They also create financial models which help them even more, and bridge the gap between soft finance and hard mathematics. There are many financial models, the most common ones can be found in this Wall Street Prep guide. Once they are comfortable that a company is on firm financial footing, they delve into the business model, products, and debt structure to see how well a company is run, what competitive advantages they can maintain, and what kind of pricing power they have. Finally, they will try to value intangible assets into the equation such as brand strength or intellectual capital.
Since they tend to be analytical in nature and because financial data is such a critical piece of this strategy, Value Investors love financial metrics. You can often identify these investors by the terminology they use when discussing investing. For example, you will frequently read or hear some of the most popular terms such as; price-to-book ratio, intrinsic value, shareholder's equity, Return on Equity, debt-to-equity ratio, and dividend yield. You can bet that when you hear one person use several of these terms during a conversation, he or she is a value investor that does a lot of fundamental analysis.
There is a steep learning curve for beginning Value Investors. To master this strategy, you have to master fundamental analysis and this means you are going to have to accumulate a great deal of knowledge. As we said above, you have to know that a company is on firm financial footing, has great products, a strong business model, and a sustainable competitive advantage. Next you have to take into account intangibles such as brand strength to determine the stock's intrinsic value. Finally, and most important, you have to be confident that the stock is currently underpriced. No easy task.
Because they put so much time and effort into studying each stock, Value Investors are much more likely to fall in love with it. Even when it becomes obvious that they must have missed something in their analysis or that something has fundamentally changed in the economic or industry environment, many Value Investors stubbornly hold onto a bad stock and wind up taking a loss that they could have avoided.
Bottom line, this is one of the most complex strategies. If you are not analytically minded and don't like delving deep into data, this is not the stock market investing strategy for you. There are many investors that call themselves value investors that, in actuality, are only bargain bin shoppers. They look for cheap stocks and their only consistent requirement is that the stock be much cheaper than it has been historically. This might work for a while with Blue Chips, but when it backfires, the losses can be significant. Stocks in the bargain bin are underpriced for a reason, they have earned their depressed stock prices through poor performance or legal woes and the stock will go much lower if their situation continues to deteriorate. If you choose this strategy, never lose sight of the fact that you are searching for companies that are undervalued, not companies that simply appear to be bargains.
The greatest strength of Value Investing is that you are buying undervalued stocks. This implies that the price of the stock is already low so you have great upside potential and some insulation against losses even if the stock doesn't take off. In other words, if you get it right, not only have you bought an investment that is likely to outperform the market, but is also likely to hold up better than most stocks in a bear market because the price is already depressed.
Another strength of the strategy is how much research goes into each stock. Most of your research will be on tangible measurements such as revenue, debt and assets to name a few. Unless company executives are itching to be behind bars, they will provide accurate data when they publish their quarterly and annual financial results. Based on your fundamental analysis, you will have a thorough understanding of the company's financial situation, their business model, their products and how competitive they are versus their peers before you ever buy the stock.
Many people considering this strategy worry that there won't be enough undervalued companies or that they will be snapped up so fast that inexperienced Values Investors can't get in at the lower share prices. You don't have to worry, the nature of the market guarantees that there will always be undervalued companies somewhere. The industry or company that was hot yesterday may be out of favor today and then hot again tomorrow.
Examples? Major banks and investing brokerages were part of everyone's core portfolio yesterday but they have been shed like old clothes since the subprime mortgage crisis began. Even those that didn't suffer large losses, such as JP Morgan Chase, experienced sharp drops in their share prices because they are part of the banking and finance industry and are therefore guilty by association. Check the industry in two or three years, it will be as strong as ever.
There are also many companies that will vanish from the headlines only to come back stronger than ever as a result of new management, deep pockets, and an innovative new product. An example? Apple comes to mind. Value Investors got pretty excited when they saw that Steve Jobs had agreed to come back in 1998 and run the company again after then-CEO, Gil Emelio, was ousted. After languishing for years, the company's share price exploded as Jobs pushed innovation that resulted in the Ipod, Itunes, Iphone and many other exciting inventions that begin with the letter I.
Value Investing is widely accepted as a proven market beater if implemented well. Warren Buffet made this strategy famous and many successful investors have beaten the market for decades implementing their own personalized versions of this strategy.
This is one of the few strategies that you can use throughout your life even though your investment goals will inevitably change. While you may move most of your money into bonds and high dividend yield stocks when you are near or in retirement, this strategy will still serve you well.
This strategy is for do-it-yourselfers that love detailed analysis and research. This is also a buy-and-hold strategy that requires a deep reservoir of patience. You will likely have to sit on a stock for years as you wait for the market to realize the stock's true value. However, if you are great at fundamental analysis this can actually be a low maintenance strategy. You work hard to select stocks and then you just sit back and wait for the market to figure out what you already know.
If you are easily influenced by others you will have a very hard time executing this strategy. Value investors need to be self-confident and self-motivated because they are Contrarians, they ignore what the herd is doing. Huh? Let's explore this point before we move on, it's important. Value Investing requires that you hunt for stocks that are currently unpopular in industries that are currently out of favor. If, for example, you are talking to a Growth Investor that wants popular stocks in hot industries, he will think you are a terrible investor. He will inevitably try to steer you to higher-potential stocks that are making the kind of gains that his are making. From his perspective, he's right, you are a failure as a Growth Investor but this has nothing to do with your strategy. Successful Value Investors don't care what other people think about their strategy or their stock choices, they care about long-term results.