If you are new to investing, you may have heard about different investment strategies for example value investing, growth investing or index investing. However, like a newbie investor, you may find yourself struggling to understand the different strategies and applying these to guide your investment decisions.
In this short article, we will explain what value investing is and what are some of the key differences between value investing and other popular types of investment strategies.
What Is Value Investing?
Value investing is definitely an investment strategy where investors focus on finding stocks that they feel are undervalued , in other words, cheaper than what they're worth. Value investors believe that not all stocks are fairly valued, and thus, if you pick and invest in the right stocks, you can generate a higher return than the market.
This may appear like a logical way to invest. In the end, as investors whose aim would be to generate a good return on our investment, shouldn't we always be on the lookout for undervalued stocks to purchase?
Value Investing Vs Growth Investing
You see, many retail investors actually are not value investors (whether they know this or not is another matter). For example, suppose we are investing in Tesla today. Based on Tesla's current financial numbers, its Price-To-Earnings ratio (P/E) is about 1,000. It is hard to argue that a value investor would find paying $1,000 to create $1 each year a good deal. In this case, we are likely to be a growth investor (or perhaps a speculative investor) who have confidence in the growth potential of Tesla.
However, this doesn't imply that Tesla or other growth stocks are bad investments. Rather, It just implies that we will probably prefer looking at other stocks as a value investor.
Value Investing Vs Index Investing
Another popular way of investing is via broad-based index ETFs. Classic examples are the SPDR S&P500 US$ (SGX: ES3) or the Nikko AM STI ETF (SGX: G3B) that track market indices, such as the S&P 500 or the STI. For investors investing in these ETFs, their primary objective would be to earn a return that is going to be similar to what the market index is earning, rather than to beat the index.
To place it into perspective, index investors aim to earn an average return much like what the stock market is making while value investors search for investment opportunities that can outperform the marketplace.
What Should Value Investors Look Out For?
In the words of Warren Buffett, \”Price is exactly what you pay, value is what you get\”.
As value investors, we want to buy what is going to be valuable. The aim is NOT to buy what is cheap, but to purchase what is valuable. To figure out if your stock is potentially undervalued, there are several key criteria we can look out for.
Price-To-Book Value (P/B): Price-To-Book Value (P/B) is the market price of the company's shares divided through the value of the company's asset on its balance sheet. A P/B that's above 1 means that a company's share is trading in a value that is higher than it value of its assets. A P/B that's below 1 means that a company's share is trading at a discount to its current asset value.
A word of caution, a low P/B value doesn't automatically mean that a company is undervalued. It could be that a company's asset is overvalued to begin with, or that the company is in an asset-heavy business that requires these to own assets for their business.
Price-To-Earnings Ratio (P/E): Price-To-Earnings ratio (P/E) is fairly easy to understand. It measures how much you are paying for a company's shares for each $1 it earns. If a company has a net profit of $100 million annually and it's worth $1 billion, what this means is its P/E is 10.
Instinctively, the low a company's P/E ratio is, the more undervalued it may appear to be. Having said that, it is important to delve deeper into its earnings. There's a likelihood that a company is trading at a low P/E because investors expect its current earnings to be unsustainable.
Price/Earnings-to-Growth (PEG) Ratio: P/E ratio does not take into account expected earning growth. This is where Price/Earnings-to-Growth may come into play like a more accurate indicator to assess the value of a stock. PEG can be calculated if you take [(Price/EPS)/EPS Growth].
If a company has a net profit of $100 million a year and it's worth $1 billion, what this means is its P/E is 10. If its earnings growth rate is 20%, this means its PEG ratio is 0.5. The lower a PEG, the more undervalued a regular is considered to be.
Does Value Investing Work with Retail Investors Like You & Me?
Whether Value Investing is a good strategy depends on our views of the financial markets. If we think the market is always efficient, then it's reasonable to state that value investing doesn't exactly work. Whenever there is a valuable stock, the market will respond promptly and price it such that we will not find an undervalued company.
However, markets are not always efficient. Some stocks that are the flavour of the month might be overvalued while some other quality companies are undervalued because fewer investors know about them.
As a value investor, if we are willing to put in the effort to learn, research and analyse these businesses, then we may find undervalued stocks. Of course, this is easier said than done. Value investors need to be very familiar with the industries and companies that they have shortlisted. We cannot find undervalued stocks if we do not know what to look for in the first place. With no, taking advice from a friend or perhaps an 'investment expert' doesn't count as research.
Also, even if we find a handful of undervalued stocks, it's worth noting that they can remain undervalued for some time. Often, undervalued stocks are undervalued in the first place for a good reason. It could be that they are within an industry that is not sexy and overlooked by both institutional and retail investors. Thus, if our plan's to invest for a short period of 1-2 many sell it off thereafter, value investing might not work for us.
Finally, as a value investor, it's advisable that we should look at both Singapore and overseas markets. The straightforward reason is that finding undervalued stocks is not always easy and there may be periods where the entire market or industries are overvalued. By having a bigger market to choose our undervalued stocks from, we might discover more investment opportunities. Having said that, the fundamental principle remains that we should fully understand the companies that we're choosing to invest in.