As stock investors, you’re more like to concern about the sudden market crash and downfall of the stocks you invested in. This fear psychosis may prevent you to enter into the market and buy your desired stocks. Here in this context, the concept of value investing surfaces. The value investor follows the same financial strategy as growth investors. Unlike some investment strategies, the value investing is simple and not a rocket science. It doesn’t require an extensive background in finance, but understanding the basics of stock investing is needed here. If you have common sense, patience, money to invest and the willingness to learn, you can become a value investor.
Value investing is all about buying stocks at bargain price. But how should you go about looking for bargains in a market where most of the great companies look expensive? Yes, the value investor in the investment game is always looking for more bangs for the buck. Value stocks often are neglected by many investors and they do not get a lot of positive fanfare. Their sales and earnings are growing at a pace slower than overall market. Value investors are looks like frugal and always hunting for bargain price. Going against the norms, they buy shares by investing money in them that are cheap when others are more pessimistic about them.
Benjamin Graham is considered the father of value investing. He was aware that the investor who ignores valuation concerns and overpay for their investments are operating with a zero margin of safety. Here the margin of safety means that those investors should only purchase a stock when it is available at a discounted price to its underlying intrinsic value. You’re buying a stock where the price/earnings ratio is less than 40 percent of the average P/E value over the last 5 years. And the dividend yield is greater than two-third of the high rated corporate bond yield, a stock price less than two-third of the book value, and current assets greater than twice the value of current liabilities.
Though Graham put forward his investment theories in the 1930, his theory is still relevant even today. The renowned modern investor Warren Buffett is also follows his techniques.
Factors to be considered for screening for Value Stocks:
The value investment is usually regarded as safe investments and there some financial ratios play crucial role. The ratios of historical and forward price/earnings, price/book value, price/sales, and price/cash flow of companies are practiced by value-focused portfolio managers too. As a value investor, you should aware that the companies which are losing their money will show up with price/earnings ratios that are negative. Strict value investors look for their stocks to be trading close to or below their book values.
The value investor should also consider the debt ratios and the dividend yields of potential investments. A good value stock should have low debt levels, good cash flow, and a high credit rating. Good value stocks should ideally have strong cash flows and dividend above the S&P 500 (An American Stock Market Index). The high yield gives a cushion, should a stock do not offer capital appreciation. They’re likely to return a higher proportion of their earnings directly to their shareholders.
Usually the value stocks are less volatile than their peer’s growth stocks and have a beta below 1.0 And in bear markets they’re more likely to hold up better and lesser downside risk than the growth stocks. But they may fail to keep up with their upside potential in bull markets. Even value investors need to have patience when a company is truly undervalued. Value stocks are weighted heavily in defensive sectors such as financials, real estate investment trusts, and utilities.
But you may raise a question as why is it a value stock and cheaper one? Well, to be true, a company becomes a value stock may due to some reasons. 1. This is in an out-of-favor industry, 2.Analysts may have low prospects for the company, 3.The stock price is historically at low levels, 4.The company is restructuring its businesses, and 5.The company is fighting hard for its own survival.
In terms of market capitalization, an investor can be biased to own a value stock to be a large cap. The large cap stocks, with market cap above $5 billion, are more likely to survive in an industry passing through hard times. They generally are stronger financially and can get easy financing than its small caps counterpart. A large cap stock can be in better position in terms of price wars and the tightening of profit margins. Lastly, large cap stocks usually are better ones in diversification of their revenue streams for their customers and product lines. If one business of a company is struggling, there is a high chance that another segment of the corporation may be doing well to offset some of the problem areas of their business which the value investor need to understand reasonably.
But small companies generally do not have this kind of luxury. Moreover, business investment of larger cap companies is more multinational in nature having much more exposure to international markets than small cap stocks. The primary concern for value investors is that the stocks they invested in are cheap. This is because of their future prospects appear to be grim. In most cases, it takes time for a company to turn itself around. The value investor need to have a long term view, instead of short term windfalls. Here, you may consult to a technical analyst about the historical price chart of the stock to be doubly sure that you’re heading in the right direction. In stock market there is a proverb all around that “A trend is a friend” and you’ve to ride an uptrend to be more successful in stock market in addition to sound fundamental views. Stay tuned, I’ll discuss more about technical matters in my upcoming articles.