Value stocks are those that are trading at a lower price than their intrinsic (or fair) value.
The intrinsic value is essentially the price value investors think a stock should be trading at.
Investors identify value stocks based on the margin of safety principle; the difference between the trading price and the intrinsic value. The wider that is, the better the opportunity.
In contrast to growth stocks, investing in value stocks is considered a more conservative, long-term approach. This is because value investors only buy a stock at a lower price than what its fundamentals indicate it should be trading at, hoping to turn a profit later when the stock reaches its potential.
In this article, we will show you a few characteristics of value stocks, the pros/cons that come with investing in them, and how they differ from growth stocks.
Key characteristics of Value Stocks
A value stock has several key characteristics. First, these stocks typically trade at significantly more affordable prices compared to growth stocks. In general, value stocks can be found within a sector that trades at lower prices than the broader market.
Moreover, value stocks generally have lower price-to-book (P/B) and price-to-earnings (P/E) ratios than growth stocks. Therefore, investors buying value stocks usually expect higher returns in the long run as it takes time for the broader market to recognize their inherent value.
Investors can identify value stocks by looking at some key metrics of stocks. Here are the most important ones:
Low P/E ratio – Put simply, the P/E ratio is a metric that tells us how many times over a company’s earnings the market is willing to pay. It does that by dividing the total current price of its stock by its earnings. The lower the ratio, the less the market is willing to pay for the earnings; therefore, the more undervalued the stock may be. Most analysts look at the average P/E of the industry a stock is in to see if it’s higher or lower than a stock’s.
Low P/B ratio – The Price to Book value ratio (P/B) examines how many times over the total net worth of a company the market is willing to pay for its stock. Book value is that net worth, commonly referred to in the balance sheet as the “equity”. As with the P/E ratio, analysts use the average P/B of the industry as a benchmark. But some investors like to see a P/B ratio of less than 1, which would indicate that the price of the stock is actually lower than its book value or total net worth.
Low P/S ratio – The Price to Sales (P/S) ratio measures how many times over the sales of a business the market is willing to pay for its stock. As with the previous metrics, analysts will compare the P/S ratio of a stock to that of its industry to see if it’s undervalued.
What are the Pros of Investing in Value Stocks?
One of the key benefits of value stocks is that they carry significantly less underlying risk and are less volatile than other short-term investment opportunities. The reason for this is that value stocks trade below fair value and the downside is limited.
The market can still push a stock’s price even further down, but if the fundamentals of the underlying company are solid, they will almost definitely be recognized in the long run; and the price will reflect that recognition.
Another advantage as significant as the low risk associated with this approach is lower costs; and, therefore, higher returns.
Value investing is based on a buy-and-hold strategy. Sometimes, investors hold a stock for years, waiting for the price to reach its intrinsic value. This delays the cost of taxes and transaction fees when gains are realized during selling.
Consider an extreme case of two portfolios with the same returns over 10 years, for instance. The only difference is that each year the first has a turnover of 100%, which means that all stocks are sold and replaced with new ones. The second buys and holds the same stocks for the whole period.
The costs associated with selling (both taxes and transaction fees) cut away from the profits each year, making the first portfolio’s returns less than those of the second over the long term. Sure, the second portfolio’s gains are going to get taxed too, but only after 10 years; in the meantime, the invested capital has the benefit of returns free from annual costs. The delayed expenses would have allowed the returns to compound on a greater scale.
What are the Cons of Investing in Value Stocks?
Like any other investment strategy, value investing also has its disadvantages.
Value investing requires adopting a unique mindset, which requires patience and a long-term investing approach. This is because value stocks usually require time to turn the underperformance into the outperformance.
In this context, emotions can negatively affect investors, urging them to make impulsive decisions, which more often than not result in losses. Some investors may run out of patience to hold value stocks and may turn to growth stocks as they look to capitalize quicker on market turns.
Another disadvantage of value investing is that it requires a great deal of financial knowledge and experience. Investors need to spend a significant amount of time and effort to identify undervalued stocks that are likely to outperform the broader market in the long run.
Value stocks are significantly more difficult to identify than any other type. And no doubt; if they are truly undervalued, that means that the market is ignoring them and analysts don’t cover them.
Last but not least, a value stock’s price may take a long time to reach its fair value. This means that some part of your capital isn’t generating any returns for years. Such misfortune can only be offset by outstanding returns when the market recognizes that stock’s value. You may not lose money, but your returns may not be satisfying either.
The difference between Growth and Value Stocks
The primary difference between value and growth stocks is that the latter carries a stronger growth potential but also comes with a higher risk.
From another perspective, value stocks carry less risk but may not grow as fast as growth stocks. Because of this, many investors prefer to diversify their portfolios by investing in both value and growth stocks.
Another key difference is that value stocks can generate returns only when the market recognizes its intrinsic value. Growth stocks have ever-increasing prices in a bull market, resulting in continuous returns as long as the bull market lasts.
All in all, investors with a longer time horizon and a lower risk appetite are likely to prefer value stocks compared to growth ones, which offer higher returns in the short term but are also more expensive and often associated with high risk.
Example of A Value Stock
We already laid out some key metrics that analysts look at to identify value stocks.
Here’s an example of a value stock that would look attractive to professionals based on these metrics…
As of 4/4/2022, Barclays, a UK bank, had a P/E of 3.7x, a P/B of 0.4x, and a P/S of 1.2. While these numbers may look low enough, consider those of the Diversified Banks industry to see if Barclays’ stock is undervalued: P/E: 7.3x; P/B: 0.8x; P/S: 2.3x.
As you can see, the stock does look undervalued when compared to its industry.
All in all, investing in value stocks is a popular way to limit your downside while placing your capital in a position to potentially make great returns in the long term. This approach is quite opposite of growth investing, which involves a much higher degree of risk but can also offer more attractive returns.
In essence, value investors attempt to identify opportunities that offer good value for money invested. Value stocks aren’t expensive, which allows patient investors to play the long game and wait for these companies to fulfill their potential.
All in all, value stocks are definitely for you if you can delay gratification for years. As you wait, however, you might as well pick a few growth stocks along the way for diversification.
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