Value investing: what it is and how it works

Value investing vs. growth investing

As previously mentioned, value investing focuses on finding stocks trading below their intrinsic value, offering long-term investors an opportunity to buy quality companies at a discount. In contrast, growth investing takes a different approach, targeting companies that are expected to grow faster than the overall market.

While value investors look out for undervalued stocks with solid fundamentals, growth investors focus on companies with significant potential for future expansion. These growth companies are often found in dynamic sectors like technology, where innovation drives rapid earnings growth.

However, unlike value stocks, growth stocks are typically priced at a premium, reflecting their anticipated future performance.

Risk and reward

Value stocks can offer a margin of safety due to their lower market price relative to intrinsic value, making them less volatile in times of market uncertainty.

On the other hand, growth stocks often come with higher risk, as their success depends on future performance rather than current fundamentals. Investors in growth companies are betting on continued rapid expansion, which might not always happen as planned.

Which strategy is better?

Historically, value investing has performed well during periods of economic recovery or market corrections when investors seek stability and lower-risk investments. Growth stocks, conversely, tend to outperform in bullish markets when optimism about future earnings drives up prices.

Choosing between value and growth depends on market conditions, investment goals, and risk tolerance, but both approaches have their strengths in the right environment.

Value investing strategies

Value investors use a variety of strategic approaches to uncover opportunities in the stock market. Here are some of the most notable ones:

Contrarian investing

Contrarian investors deliberately take positions that go against the prevailing market sentiment. They seek out companies that are currently undervalued due to negative market sentiment or temporary setbacks. By focussing on the long-term fundamentals of these companies, contrarian investors aim to profit once the market corrects its overreaction.

Deep value investing

Deep value investors look for stocks that are trading at extreme discounts, often well below their intrinsic value. These stocks are typically distressed or out of favour due to significant market pessimism or operational struggles.

This strategy carries higher risks but offers potentially substantial rewards for those able to identify companies with the potential to recover or be restructured.

Dividend value investing

This strategy focusses on finding value stocks that not only trade below their intrinsic value but also provide a steady dividend yield. Investors using this approach aim to generate regular income from dividends while waiting for the stock's market price to appreciate.

This method is often favoured by income-focused investors who want a combination of capital appreciation and passive income.

GARP (Growth at a reasonable price)

This strategy combines principles of both value and growth investing. Investors following GARP look for companies that exhibit consistent earnings growth but are also trading at a reasonable valuation.

Essentially, they seek to find companies that are growing steadily but haven't yet become overpriced. GARP investors use metrics like the PEG ratio (Price/Earnings to Growth) to assess whether a growth company is still undervalued relative to its future earnings potential.

Low Price-to-Earnings (P/E) strategy

This is a classic value strategy that targets stocks with low P/E ratios. The idea is that a low P/E ratio indicates the market has undervalued the company's earnings. Investors using this strategy believe that as the market realises the true earning power of the company, its stock price will rise accordingly.

Net-net investing (liquidation value)

Popularised by Benjamin Graham, this strategy focusses on finding companies trading for less than the value of their net assets (total assets minus total liabilities).

Investors target companies that are priced at or below their liquidation value, meaning the company could be worth more if it were to be dissolved and its assets sold off. This strategy is rare but can lead to substantial returns in specific situations.

Behavioural biases and value investing

Market psychology plays a crucial role in creating opportunities for value investors. Emotional reactions and cognitive biases often cause stock prices to swing away from their intrinsic value, presenting chances to buy undervalued stocks. While fear and greed can dominate market behaviour, value investors focus on the long-term fundamentals.

How market psychology creates opportunities

When negative news hits or economic conditions worsen, investors tend to panic, leading to sharp selloffs. In these moments, stocks can become undervalued despite solid fundamentals. Value investors see these drops as opportunities to buy quality companies at discounted prices.

Conversely, during periods of excessive optimism, stock prices may rise far beyond their true worth, driven by speculation rather than substance. Value investors typically avoid overhyped stocks, knowing the market will eventually correct itself.

Common market biases

Here are the most common market biases:

Overconfidence bias

Investors often believe they can predict market movements better than they actually can. This overconfidence drives risky behaviour, especially in bull markets, where stocks may become overpriced. Value investors stay grounded, preferring solid fundamentals over speculation.

Loss aversion

The fear of losing money often leads investors to sell during downturns, even if the company's fundamentals remain strong. Value investors take advantage of this, buying when others are selling out of fear.

Herd mentality

Following the crowd can push stock prices too high, especially when hype surrounds a company. Value investors go against the grain, buying stocks that others have overlooked or abandoned, confident in the eventual market correction.

Is value investing dead?

In recent years, value investing has faced scrutiny, especially as growth stocks in sectors like technology have dominated the market. This has led some to question whether value investing is still relevant in today's economy.

While growth stocks have indeed outperformed value stocks in certain periods, declaring value investing ˈdeadˈ would overlook its proven long-term performance.

The case for value investing's struggles

The last decade has seen unprecedented growth in industries like tech, where companies are often valued for their potential rather than current earnings. Investors have flocked to growth stocks, driving up their prices and making it seem like value investing has lost its edge.

Easy access to capital, rapid innovation, and low interest rates (for the most part), have also skewed market sentiment toward high-growth companies.

However, the underperformance of value stocks is cyclical. Historically, periods of market correction or economic uncertainty have favoured value stocks as investors seek safer, more stable investments.

The principle of buying undervalued assets at a discount and waiting for the market to correct still holds true, particularly when speculation in growth stocks leads to unsustainable price levels.

Conclusion: Why value investing remains relevant

While growth stocks have seen periods of strong performance, value investing is far from obsolete. In fact, the cyclical nature of the market suggests that value stocks often outperform during recovery periods. Value investing offers a margin of safety that growth investing lacks, providing a buffer when markets become turbulent.

The strategy's focus on strong fundamentals and reliable business models is timeless. Investors who stick to value principles know that patient, disciplined investing often pays off in the long run, especially after bubbles burst and speculative trends cool off.