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What Actually Is The Definition Of A Value Stock?
"If it's a bad bargain, nobody gains." That's my second favorite quote from the movie Wall Street, just behind "right in the ass you fucking scumbag cocksucker," but that quote doesn't apply quite as well to today's topic.
When we take a look at the world of investing bargains, it turns out that Oliver Stone knew what he was directing. Wall Street, released during the halcyon days of 1987, was also in the heyday of Berkshire Hathaway, the only insurance company most people give two shits about. That's also the crown jewel of the grandfather (granddaddy?) of value investing, Mr. Warren Buffett.
Today, we're embarking on a journey to demystify the concept of "value stocks." Before we dive into the depth of the term, let's warm up by understanding the concept of value investing, a style pioneered by the legendary duo Warren Buffett and Charlie Munger, with roots traced back to Benjamin Graham and David Dodd.
Psychology of the Value Investor
Value investors are the bargain hunters of the stock market, digging deep into a company's financial statements, scrutinizing balance sheets, cash flow statements, and income statements. Their goal? To determine the company's intrinsic value, its "true value" independent of its current stock price or market value. If the stock's trading price is less than its intrinsic value, it's deemed a good value. In short, the goal of value investing is to find stocks trading for less than their intrinsic value.
Talking Intrinsic Value
What exactly are value stocks? Well, these are shares of a company that appear to trade at a lower price relative to their fundamentals, such as dividends, earnings, or sales, thus having a high dividend yield, low PE ratio (price-to-earnings ratio), and often, a low PB ratio (price-to-book ratio). Unlike their counterparts, growth stocks, which are favored by growth investors for their above-average growth in earnings or revenues, value stocks tend to belong to mature companies operating in sectors like the financial sector, and less often in high-growth industries like information technology. But why would someone invest in a "value" over something labeled "growth?" For that, let's look at the world of basketball.
The Role of Value in Sports
Flash back with me for a moment to June 26, 2014, in Brooklyn, NY. We're at the Barclay's Center for the NBA Draft, a moment young men dream about. There, 30 men are about to become overnight millionaires in the first round of the draft, with 30 additional men scrapping for a roster spot in the second round. In basketball, you're hunting for star potential at the top of the draft, and value potential at the bottom. If you're picking first, you want the "best" player, whether that means they're ready to play right now, or they have the highest potential for growth. If you're hunting later in the draft, or in the second round, you're looking for value. Who fits on the roster? Who has a role to play, and can play it well?
The 2014 NBA Draft started with Andrew Wiggins selected at #1 overall. Viewed as the best player with a bit of room to grow, Wiggins really didn't fulfill his potential at all until the 2022 NBA Finals, which he won with the Golden State Warriors. The number two pick? Joel Embiid from Cameroon, viewed as the biggest unknown, but the absolute highest ceiling you could assign to a player.
Let's jump to pick #41. With the 41st pick in the 2014 NBA Draft, the Denver Nuggets select Nikola Jokic, Power Forward from Serbia. Jokic was so unknown that the ESPN broadcast literally cut to a Taco Bell commercial during his pick. But Jokic was viewed as a value. A big man with potentially untapped potential that could play a role in a team. Well, turns out his role was to win back-to-back MVP's and the 2023 NBA Championship, signing a super-max deal as one of the most skilled Centers in NBA history. This, my friends, is why the value picks can pay off.
Intrinsic Value vs Price
Why might a stock trade for less than its intrinsic value? There are various reasons, but often it's because the company has fallen out of favor with the market, perhaps due to a temporary setback or an economic downturn. This mispricing presents an opportunity for value investors to acquire high-value stocks at a discounted market price.
Some classic examples of value stocks include those in the Berkshire Hathaway portfolio, the company I previously referenced that turned midwesterners to west coast-ers pretty damn quickly. These firms often exhibit slow growth but generate steady profits and free cash flow. Their book ratios (the company's book value compared to its market value) often reveal that they are undervalued, making such stocks potentially good buys for the long term.
Performance of Value Stocks
The performance of value stocks, like all kinds of stock, depends on a multitude of factors. In recent years, the "value factor," a term used to denote stocks with low price-to-earnings and low price-book value, has underperformed growth investing. Yet, as the wise Buffett once noted, "Price is what you pay; value is what you get." This quote embodies the very essence of value investing (and the selection of Serbian big men). The stock market, with its short-term focus, often overlooks companies that offer good value for the long run.
But, because it's a value stock, does that mean that your stock pick is destined to outperform? No.
It's important to mention that past performance of value stocks is no guarantee of future results. Remember that investing in the stock market always involves risk. Market share, earnings ratio, and a company's business model, among other things, may change over time. Also, external factors like market sentiment, economic trends, and company news can impact a stock's share price.
Investing in Value vs Growth Stocks
While the investment objectives of value investors and growth investors differ, both strategies can coexist in a diversified portfolio. Mutual funds, for instance, often include both growth and value stocks to balance growth potential and value opportunities. Meanwhile, institutional investors and financial analysts leverage their expertise and resources to identify the best value in the market, potentially leading to excess returns.
Value investing isn't a one-size-fits-all strategy, and beginner investors should evaluate their financial situation and investing goals before jumping in. Financial analysis of a company requires time and a keen understanding of financial metrics, such as PE ratio, Price to Book (PB) ratio, and free cash flow.
Furthermore, sectors with a high concentration of value stocks, such as financials and industrials, may face different risks than growth sectors like technology or consumer discretionary. Consider the efficient market hypothesis, which posits that stocks always trade at their fair value, making it impossible to outperform the market consistently through expert stock selection or market timing. Value investors, however, argue that market inefficiencies do exist, creating opportunities for savvy investors to achieve higher returns.
A variety of tools can help investors identify potential value stocks. Value indexes like the FTSE Russell Index and various stock funds focus on value stocks, offering both individual and institutional investors a straightforward way to incorporate value investing into their portfolios. For those interested in a more hands-on approach, direct stock plans offer a way to buy shares directly from companies.
Market capitalization is another important consideration. Value stocks can be found across the spectrum, from small-cap to large-cap companies. Large caps, often considered more stable, may pose lower risk, but smaller companies might offer greater potential for growth.
Value Investing: You vs Wall Street
You, the advanced investor that reads this site three-times per week and understands the value of a dollar, is likely an investor with a view to the long-term. Your time horizon is longer than the Adderalled-out swing trader down the street who has to beg the bank to not take their home.
Wall Street, with its myopic focus on quarterly earnings and short-term results-based compensation model, often overlooks the underlying value of a company's assets, such as real estate, machinery, and intellectual property. For value investors, this is where the opportunity lies, for the true value of the company often includes these overlooked assets. In the long term, they believe the market price will correct itself to reflect the company's intrinsic value accurately.
Noting Value Traps
A word of caution, however: not all cheap stocks are bargains. Financials can be like bikinis - they show a lot, but not everything. Sometimes, a stock is cheap for good reason—perhaps the company's business model is flawed, or it faces insurmountable challenges. This is where careful financial analysis comes in. Look at the company's earnings growth rate, its market share, and how much cash it has on hand. Analyze its debt levels, which can be found on its balance sheet. Be mindful of potential red flags, such as consistently declining revenue or profits, or excessively high debt levels. Your research is key in determining what is a value stock, and what is a value trap.
Investing in value stocks is not a short-term game. As David Dodd once said, "The stock market is filled with individuals who know the price of everything, but the value of nothing." It's about patience and sticking to one's convictions, despite market volatility. The sale of any security should not be based solely on its recent price but on a thorough analysis of its intrinsic value.
In closing, while no single investing strategy offers a guarantee of success, value investing provides a systematic approach to identifying undervalued stocks, with the goal of achieving higher returns in the long run. This approach requires diligence, patience, and an understanding of both a company's financial situation and the overall market. Additional information and resources are always beneficial, as they help refine this strategy for optimal results.
Remember, the idea is not to buy a stock because it's cheap, but because it's cheap relative to its actual value. Despite the dominance of growth investing in recent years, the philosophy of value investing continues to thrive and offers a viable path to achieving long-term investment strategy objectives. So the next time you're scanning the financial sector or any other sector of the stock market, consider the value approach. As Warren Buffett once said, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." Happy investing, folks!
