As a favoured strategy by many of the world’s top investors, including Warren Buffett, everyday Aussies are now finding the real value in these stocks, over perceived riskier options like growth stocks.
For new investors starting their investment journeys in 2021, here’s a look into value stocks, and why it might be a good time to invest in companies with inherent value.
What are value stocks and value investing?
Value stocks are companies with share prices that are lower than what their fundamentals suggest they should be. Some examples of popular value stocks include Target, Johnson & Johnson and JP Morgan.
Value investors look at these stocks like they’re on sale. They identify companies with low prices and high potential, buy those shares, and then profit when other investors eventually realise what they’re missing out on and buy in at higher prices.
When it comes to an investment strategy, value investing is a long-term, conservative approach to investing. When investors invest in value stocks, they’re looking to ideally buy and hold companies whose share prices are currently lower than their intrinsic value.
These value investors analyse metrics like a company’s performance, profit, revenue, cash flow, price-to-earnings ratios, along with a host of other financial information, such as the CEO’s vision for the company.
The strategy of investing in value stocks was pioneered by Benjamin Graham in the 1920s, who is now more commonly known as “the father of value investing”. Not only the mentor for Warren Buffett, Benjamin Graham wrote the book The Intelligent Investor, which has gained recognition as the foundational work in value investing.
The pros and cons of value stocks
Like most stock types, value investing has many benefits and some downfalls that investors should be aware of before considering adding them to their investment portfolios.
The first benefit is that value investing is subject to less risk and volatility than most short-term investment strategies. Why? Because investors are not buying stocks today and selling them tomorrow, they don’t necessarily have to get caught up in daily market price fluctuations.
Value investing can also generate spectacular gains, as an underestimated asset can reveal its true worth and yield fruit because market players don’t feel bearish about them.
Value investing is an ideal way to take advantage of the power of compounding. Compounding is when people reinvest the returns and dividends earned from value stocks, their profit will grow significantly over time and their earnings will eventually begin to generate earnings of their own, with minimal extra outputs required.
With benefits, also comes downsides.
The biggest one is that it can also take a long time for an undervalued stock to return to its intrinsically fair price, and value investors may have to hold their positions for years until the market sentiment changes in their favour.
When interest rates decrease and company earnings go up, growth stocks tend to gain ground over value stocks. Investors are willing to pay a premium for growth stocks in this scenario. As most value stocks are cyclical, they tend to do well in economic recoveries, but lag in bull markets.
Is now the best time to buy value stocks?
Up until recently, growth stocks were king of the investment world (between 2017 and 2020), as a result of a rare confluence of events. This included the wave of technological innovation highlighted by the emergence of cloud computing, and the accelerated adoption of e-commerce and a migration to mobile. These occurrences drove growth stocks to new heights.
While value stocks’ ascendance was driven by not only the global pandemic, but also the unprecedented levels of fiscal and monetary stimulus that has enabled the US economy to rebound much quicker than anticipated from the virus-induced recession.
Despite this, overall the outlook for value investors is still somewhat positive. Cyclical sectors are in focus due to the strong recovery in most economies worldwide, and many investors are rotating out of growth stocks and diversifying into these sectors in order to find returns.
Value stocks have effectively been out of favour for many years as most investors focused on other types of stocks, we now see that investors are picking up value stocks with cheaper valuations after a difficult 2020.
Josh Gilbert, market analyst, eToro