How Does Value Investing Work?

What makes the value investing style different from growth, and how can it benefit your portfolio?

Sunniva Kolostyak 24 August, 2021 | 10:26AM
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Whether to invest with a value or a growth focus is always a big discussion between investors. But what is it, how do the two methods differ from each other, and is the strategy right for you?

Let’s start with the basics – what is value investing? Put simply, it means buying stocks that are perhaps overlooked and unloved, trading below their intrinsic value, with the anticipation that markets will realise this and the price will go up. This strategy is believed by many to be less volatile than growth, as well as outperforming over the longer term.

The idea of value investing was coined by Benjamin Graham and David Dodd, who taught at Columbia University in the 1920s. Graham's strategy was to look for stocks priced at 66% or less of the company’s underlying assets.

One of the most successful investors of all time, Warren Buffett, follows this principle. He relies on a set of rules that including have a safety margin, have patience, and don’t get swept up by short-term noise.

“I don’t have to make money at every game,” Buffett said in one of his interviews. “In the securities business, you literally have every day thousands of major American corporations offered to you at a price that changes daily, and you don’t have to make a decision... You can sit there and look at thousands of pitches and finally get one right there where you want something that you understand and then you swing.”

Value vs Growth

So how does value vary from growth strategies? While value is about identifying hidden gems, growth investors tend to be attracted to companies that are expected to grow faster, and where demand often drives up the price. As an analogy, value is like buying clothes from the sales rack that you believe will be worn for years to come, while growth is like buying the latest trendy items that you can resell for a profit. Typical characteristics of growth stocks include high growth rate, low or zero dividends and higher risk, with stocks like Netflix (NFLX), Alibaba (BABA) and Tesla (TSLA) being great examples.

In general, low interest rates favour growth stocks, and 2020 was certainly a year for this type of investment. But historically, value stocks deliver greater returns over the long run as there’s more room for the company to grow. 

Does Value Really Work? 

It all sounds very simple, but it can be hard to identify stocks that fit into the value theory. And while the value principle works over the longer term, the strategy faced challenges between the 1990s and 2010s, and has proved to be less reliable in some down markets. Critics have also pointed out that studies into growth and value strategies have not considered the cost of buying and selling stocks, which eats into returns.

But what is clear, however, is that recent months have provided a remarkable recovery for value stocks. As previously mentioned, growth industries like technology and disruption-driven companies saw fantastic growth through the pandemic while airlines, oil, banks, energy and cyclical parts of the market struggled. However, if you invested in these areas before (or during) the pandemic and remained patient, you should currently be doing well.

With a more hopeful market in 2021, value stocks have been outperforming. Current concerns over the Delta variant are throwing a wet towel over recovery projections, but fund managers believe the value rally will be able to continue.

Vincent Ropers, manager of the Wise Multi-Asset Growth Fund previously told us: “The key to remember is that we've been waiting for that value rally for a very long time, pretty much since the great financial crisis. So, despite the rally that we've seen, that started in Q4 last year, there is still a lot of room for value to catch up with the growth strategies. And we think there is a lot more to come.”

Spotting a Value Trap

It is important to note that cheap and value are different concepts, and investors should not blindly buy stocks simply because they appear to be a bargain. A low price can be a lure, or a value trap, and it is important to spot warning signs such as disruption to the business or industry.

One tool to utilise is Morningstar’s Star Rating for stocks, which estimates the fair value of a stock based on the characteristics of the underlying business, including future cash flows and the risk inherent in the stock. A 4 or 5 Star rating indicates the share’s current price is below its fair value and there is a margin of safety, while a 1- or 2- Star rated stock indicates that at the current price the share is not good value. We have recently looked at the world's most undervalued stocks, taking into account how far below the fair value estimate shares are trading.  

Being a value investor is not always easy and it requires an investor to be contrarian by investing in unloved and out-of-favour areas of the market. But the likes of Graham, Dodd and Buffett would argue that the gains are worth it over the long-term. 

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Sunniva Kolostyak  is data journalist for Morningstar.co.uk