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Understanding how value investing works

September 29, 2009 13:54 IST

If you are interested in stock markets and other investment options, you might have come across the term 'value investing'. But, do we really know or understand 'value investing'?

This article tries to clarify this term and help you gain a better understanding of how investments are made. But before we look at this term we have to understand that investments in stocks are made based on their value in the market.

The better the value of the stocks, the higher are the chances of the stock selling in the market, and more profits for the investor. However, sometimes the stocks are not valued properly and this may result in the stock performing lesser that what it could have been.

What is Value Investing?

Value investing involves buying an undervalued stock and selling it when the market finally recognises the stock's potential.

Value investing can be simply understood as investing in something that the market currently values less than what it is actually worth. The concept of 'value' may be different for different investors.

While some of them consider only the present assets of a company to determine the intrinsic value of its share, others base their estimation entirely on the company's growth prospects.

How did it originate?

Value investing is an investment paradigm that derives from the ideas on investment and speculation that Ben Graham & David Dodd began teaching at Columbia Business School, United States in 1928 and subsequently developed in their 1934 text Security Analysis.

How is Value Investing done?

Value investing generally involves the buying of under-priced shares. Whether the share is under-priced or not, is established by some forms of fundamental analysis. Examples of such under priced securities include stocks having:

  • High dividend yields
  • Low price-to-earnings (relationship between the stock price and the company's earnings) multiples
  • Low price-to-book (relationship between the stock price and the value the market places on the book value of the company) ratios

Also, stocks trading at a discount to their book value can be considered value investments. Other strategies include opting for stocks with low price-to-cash-flow ratios. There are many ways of evaluating the success of value investing. One could indulge in value investing by observing the strategies of well known investors.

What are the benefits and dangers of value investing?

Benefits

The ability to select a company with strong fundamentals can earn gains in the long run.

Numerous academics have published studies investigating the effects of buying value stocks. These studies have consistently found that value stocks outperform growth stocks and the market as a whole. By compounding through dividends, they can be among the most profitable investment options in one's portfolio.

Value stocks have usually led the initial leg of a market recovery from a bear phase

Besides this, a recent 10-year analysis shows that though growth stocks have made the most of the bull markets during their momentum years, value stocks did much better in containing falls during the inevitable reversal.

Given the tendency of the Indian market to swing (without warning) from a bull to a bear phase once every few years, it is the MSCI Value Index that has built up a better long-term track record than the Growth Index, till date.

Disadvantages

  • Given the huge number of companies that float their shares in the market, it becomes extremely difficult to find a stock of a promising company that is undervalued by the market
  • Over dependence on value investing can minimize one's earnings potential
  • When buying shares in a bear market is that despite appearing undervalued at one time, prices can still drop along with the market
  • Stocks that are trading at a low valuation, could yet get cheaper as the company's business or liquidity conditions deteriorate.

Are there any popular Value Investors?

There are many value investors who are strong followers of this philosophy. These investors include big names such as:

  • Benjamin Graham (widely recognised as the father of this investing philosophy)
  • Warren Buffet
  • William J Ruane
  • Irving Kahn
  • Charles Brandes

Many people have made fortunes using a value-based approach to investing. Value investing is a philosophy that works over time if you buy carefully and hold for the long term.

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