Value investing has been a hallmark of sound investment strategy for over a century. The rise in popularity for value investing began in 1928 when Ben Graham and David Dodd began teaching value investing strategies at the Columbia Business School. One of the very attractive qualities of value investing is that investments made on sound value principles hold up far better during lean economic times due to the undervalued nature of the asset to begin with. Several shining examples of value investors are Warren Buffet and Joel Greenblatt who used value investing principles to consistently trounce the market over the last three decades.
To begin using value investing in your portfolio for capital preservation and long-term growth you must first understand the concepts that signify value investing. Value investments are typically securities that are undervalued by some form of fundamental analysis. Some popular metrics used to gauge value are dividend yields, book value, price-to-earnings multiples (P/E ratios), debt to equity multiples, and true or tangible book value. Using one or several of these metrics in conjunction can quickly identify undervalued securities in relation to the market at large.
Some quick research using a stock screener indentified several hundred undervalued securities using the above mentioned criteria. Many of these securities would be a welcome addition to a value portfolio but not all. Traditional value investing uses firm criteria to “help” indentify potential investments but some common sense and logical thinking are needed to aid this process. Numerous market events can skew the numbers of an otherwise unattractive security to make it look far more appealing. Here is a list of common traits to look for in a security before making a decision to invest.
– Check the dividend. Dividend yields displayed by stock screeners are often misleading. Check to see when the last dividend was paid out to shareholders and when the next one is scheduled for. Look for SEC filings or other announcements which could clue you in to the amount of the next dividend payout. Looming dividend cuts or a spotty dividend track record are deal breakers for value investing.
– Look at debt. Long-term debt can be an early warning signal. Excessive debt loads can siphon off profits and dramatically undermine book value. Compare debt to profits and consider how the company would perform if debt financing became more expensive. Numerous companies have been brought down by crippling debt loads despite showing strong revenues.
– Consider the market environment. During a growth phase balance sheets often look strong. As a company reaches market maturity competition begins eating into those lofty profits and marketing costs skyrocket. Ask yourself “How is this company positioned in the market?” and pay close attention to competitors. Look for value investments that are growing market share despite competition and avoid market veterans who are being squeezed out by changes in the competitive landscape.
– Factor in macroeconomics. This is a complicated task and many value investors are unable to accurately judge the impact macroeconomic situations may have on a security. An example of how macroeconomics can impact a security can be seen during any recession. Consumers routinely “trade down” and begin avoiding name brand items in favor of low-cost generic alternatives. A healthy understanding of macroeconomics can help to zero in on the companies most likely to boost revenues or hike dividends during a recession and avoid high fliers like Saks Inc which are likely to be pummeled when consumer demand shifts.
Value investing is not for everyone. Adherence to value principles requires a long-term outlook and a strict avoidance of margin trading or leverage. Just because you were able to identify that undervalued security in a timely manner does not mean that the rest of the world will share your view next week or even next year. It may take time for the market to unearth your diamond in the rough and drive up the valuation in relation to other securities. Keep an eye on the fundamentals which attracted you to invest and don’t let short-term market gyrations dictate your trading strategy. Much like the tortoise and the hare, history has shown that smart investments based on value principles will consistently beat out short-term profit chasers.