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Value investing explained

14 March 2017

Value investing, the strategy adopted by famous investors Benjamin Graham and Warren Buffett, has proved unpopular since the global financial crisis, but there are signs that this approach is making a comeback.

The value of investments can fall as well as rise. You may get back less than you invest. Tax rules can change and their effects on you will depend on your individual circumstances.

What you’ll learn:

  • How value investing works.
  • Why it differs from growth investing.
  • How to identify value stocks.

In recent years, investors have tended to seek sanctuary in big-name, supposedly dependable companies, but there appears to be a growing focus on stocks previously unloved by the market.

Since the start of the year the MSCI World Value Index has outperformed the MSCI World Growth index, and over the long-term, value investing has edged ahead of growth investing.1 Here, we explain how value investing works and look at some of the ways to identify value stocks.

Of course, past performance should never be seen as a reliable indicator of future performance, and investments can fall as well as rise, so you could get back less than you invested.

What is value investing?

This investment strategy effectively involves searching for diamonds in the rough, or those companies whose value isn’t currently accurately reflected by the market.

Value investors typically buy a stock when its price seems low compared to previous levels, perhaps because a company is suffering a tricky period, undergoing a restructure or carrying out a management change, which triggers a downturn in its share price.

Examples of mispricing include the tech bubble, when investors chased growth, only to see many stocks fall out of favour and slump in value.

Alongside focusing on stocks that are currently mispriced, value investors also focus on companies that pay consistent dividends, showing a company is fundamentally profitable, and paying a portion of profits back to investors. Dividends also help value investors benefit from steady, annual returns, while they wait for the stock to rise in value.

It’s important to remember, however, that dividends aren’t guaranteed. If a company experiences financial difficulties, it may reduce its payout or even stop it altogether.

How growth investing differs

In contrast, taking a growth strategy involves searching for companies that are likely to grow faster than average, based on earnings, revenue or cash flow. This involves reinvesting profits to expand the business, instead of paying out a regular income stream to investors in the form of dividends.

A value approach is typically considered lower risk than growth investing. Value investors are seeking what’s known as a ‘margin of safety’, or in other words, a gap between the current share price and its true value, over time.

Many investors choose to have a balance of both value and growth investments in their portfolio to avoid focusing too much on one particular style. If you’re unsure where to invest, seek professional financial advice.

How to identify value stocks

There are many reasons why a stock might become undervalued, or suffer a downturn in its share price, perhaps because the company is undergoing major changes such as a restructure.

Here are some signs that you may have found a value stock, based on your instincts, research, and fundamental analysis of the market.2

Taking advantage of market crashes

Sudden bad news can cause a share price to crash, presenting an opportunity if you believe this is an overreaction to current events, and there might be an upturn in fortunes over the longer term.

Cyclical changes

Different stages of the year and economic cycles see certain sectors perform better than others. Choosing a sector that’s out of favour is a good starting point to finding a value stock. 

Understand your investment

Choosing companies in sectors you have some understanding of can help your search for undervalued stocks and encourage you to keep an eye on their performance. 

Considering the detail

There are numerous ways of evaluating stocks and many are particularly technical. However, some, such as the price-to-earnings ratio, can prove useful for investors. This involves dividing a stock’s current share price by its annual earnings, as a method of comparing a particular company to another in the same sector. A lower ‘P/E ratio’ means the stock is cheaper, and could make it a value stock. 

Develop your own criteria

Once you’ve started hunting for value stocks, you’ll develop your own sense of where to invest using this tactic. Warren Buffet, for example, talks of favouring a ‘wide economic moat’, referring to a stock having a long-term competitive advantage over its peers to prevent it suffering during difficult market conditions.3

Investors looking to gain exposure to a wide range of different value companies may want to consider investing in a value fund. Funds can help spread risk because whether the value of your investment goes down or up isn’t dependent on the performance of a single company.

Find out more about our introduction to funds

Examples of value funds include L&G’s UK Alpha Trust (ISIN: GB00B28PT700) and the Schroder Recovery fund (ISIN: GB00B3VVG600), both of which invest in a range of companies whose share prices appear low, relative to their long-term profit potential.

Remember that our mentioning these funds doesn’t constitute a recommendation. If you’re unsure which investments to choose, seek professional financial advice. Bear in mind too that investments can fall as well as rise and you may get back less than you invested.

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