In these uncertain times, many traders turn to safe-haven assets and defensive stocks as they seek to keep their risk profiles as low as possible. But this leaves open the possibility that there are now many undervalued stocks out there and these could be ripe for the picking for an astute value investor.
So the question is: what is value investing and how is it done?
The nature of value investing
There is a widely held opinion that because a stock’s price is a reflection of the accumulated wisdom of all the investors who trade it, then that price will be pretty much accurate. This is what is known as market efficiency and this makes it all but impossible to “beat the market”, as there are no sufficiently undervalued or overvalued stocks available. So the best strategy for a trader is to invest in growth stocks – those companies with a long history of consistent profit-making, which will secure a steady and profitable return.
A value investor, on the other hand, does not accept that the market works quite so efficiently. This type of trader believes the market sometimes gets it wrong and that stocks are available at bargain prices which, when the true strength of their underlying companies’ financial health is revealed, will gain in price and net the value investor a handsome profit.
There are a number of reasons the market might be mistaken. The first is, of course, is market crashes, the last of which happened most recently in March because of the COVID-19 pandemic. Market panic clearly leaves many stocks undervalued. One example would be the dotcom bubble of the early 2000s, when technology shares shot up higher than many were worth before the whole lot came crashing down. After a crash, many shares suddenly become highly undervalued. Many of those shares this year are again at record highs after the global lockdown forced many people to work from home.
Another reason for mis-valued stocks is herd mentality. Sometimes people invest based on prejudice and emotion rather than market fundamentals. They might buy when everybody else does, pushing a price higher than it deserves to be through fear of missing out, or they sell because others are, leaving it undervalued because they worry about making losses. Such investor behaviour serves to exaggerate upward and downward market movements.
Investors can also oversell when unexpected bad news breaks, possibly without considering just how those headlines impact the company’s fundamentals or whether the stock is likely to bounce straight back. Such news might include an earnings result coming in below analysts’ expectations. But analysts don’t always make accurate predictions and the sell-off may leave opportunities for traders who can see the company’s long-term potential. Another cause of undervalued stocks can be cyclicality. A company’s fortunes wax and wane with the seasons or with consumer mood swings: this does not affect a company’s long-term worth, however.
Some investors spurn growth stocks and instead only seek such undervalued shares, while for others, a small, higher-risk portion of their portfolios is set aside for investment in such value stocks. Given the huge sell-offs that have taken place since March when the coronavirus revealed itself as a global pandemic, it is likely there are many bargains to be found on markets.
How to spot a bargain
Spotting an undervalued stock is not a straightforward matter. It requires detailed study of the companies you might want to invest in and a knowledge of the market that is better than many other traders. Probably the best-known value investor is Warren Buffet, who only invests in sectors he has personally worked in. He researches the company extensively and invests for the long term when he believes the value he has detected will come through.
Other than this, investors employ various metrics to measure a stock’s intrinsic value and then compare it with its current price. Financial analysis can provide an in-depth analysis of a company's performance, revenue, earnings, cash flow and profit, besides fundamental aspects such as the company's brand, management, business model, principles, financial structure, long-term plans, target market and competitive advantage. Companies that are considered value stocks will generate modest gains in revenue and earnings over a period of time. Value investors will look beyond the media headlines and the company’s short-term performance.
Calculating price/earnings and earnings yield
In evaluating a value stock, investors commonly look to see whether the company has a high dividend yield; low price/earnings (p/e), price-to-book and PEG ratios; high earnings yield; a long and consistent history; and healthy debt levels. Other investors might use a discounted cash flow model to determine a stock’s intrinsic value.
The price/earnings ratio is a common method of seeing whether a stock price accurately reflects a company’s earnings. It is simply calculated by dividing the current share price by the company’s earnings per share. The lower the p/e, the more undervalued the stock may appear to be.
However, the p/e can fluctuate over time and tends to be lower in more mature industries that are not expected to grow strongly in the near future, and higher in rapidly expanding sectors such as technology. A better indicator may be a company’s earnings yield, which divides earnings per share over the past 12 months by the current share price. The number’s significance is revealed when comparing it with earnings yield figures for other companies in the same industry sector or against the overall market level, or even against government bond yields.
The price-to-book value, instead of considering a company’s earnings, which are variable, looks to a company’s assets and liabilities and compares those to the stock price. Generally speaking, if the price is below the value of the assets, the stock is undervalued.
The book value shows the raw value of a company. Most companies trade at a value above 1, as a share price should reflect not just the assets and liabilities but also a company’s earnings potential. A value below 1 is a good indicator that the stock is undervalued, although it might equally be a sign that the company is in some trouble and this has been recognised by the market.
The dividend yield compares share price with dividend payments. It is calculated by dividing dividend per share by price. The higher the figure, the less you pay for the company’s dividends. But this can only be considered good value if the company has a long and consistent history of paying and increasing dividends.
Investors may combine these and other metrics to determine whether a stock presents value or not. One popular value screen, for example, combines earnings yield, dividend yield, earnings retention levels and return on equity.
Nothing is certain
Beyond calculations such as those outlined above, investors seeking value will also need to analyse company statements to get a picture of a company’s fundamentals and how it compares with others in the industry. A company’s annual income statement will often provide a better picture of its overall condition than its quarterly statement, as sales volumes can fluctuate over the course of the year.
Ultimately, picking the bargains that the market has missed may be more art than science. It is possible for two different value investors to study exactly the same information around a company’s financial outlook and arrive at two completely different opinions. Some will be interested only in a company’s current performance, others only in its potential for growth. Some do both.
What value investors do have in common is that they buy up stocks they believe to be worth more than they are currently priced at, hold onto them for the long term, and take profit when the shares reach what they consider intrinsic value or more.
To succeed as a value investor, you will need to do a lot of homework and to have the patience to see your predictions come true. But if you can do it right, the rewards can be handsome.