We look for value in everything we buy. Why not stocks and mutual funds? In fact, many investors and fund managers look at value before adding these investments to their portfolio. Thanks to Benjamin Graham and Warren Buffet, the value investing has been a popular strategy since the 1930s. Even though the value investing has changed drastically since then, the concept is still in vogue.
Note that the definition of value investing differs. However, a common definition that is used is “investing in profitable companies when its shares sell at a significant discount to its actual intrinsic value.” In simple terms, value investing is buying investments for less than what they are worth. Now, isn’t that a good thing? You are actually following this in everyday life. How?
Daily we purchase items which we consider to be of “acceptable worth”. In any case, the definition for value differs from individual to individual. For instance, let’s say you and your neighbour have purchased a fridge. Both of you say “my refrigerator is a superior purchase than yours”. Possibly you consider your fridge a decent deal since you got it on a special sale at a decent 15% markdown. Your neighbour, in the meantime, says her cooler is a superior purchase since it has all the most recent features when compared with another brand, at a similar cost. So, value is a part of life and has different meanings.
When it comes to investments, those who follow value investing have various reasons why they think a stock is a ‘value’ purchase. Value investing includes picking stocks that are traded at a price that is lower than their intrinsic value. Basically, you are picking stocks that are underestimated. Now, who are the best value specialists? Won’t you concur that the fund managers who handle many stocks each day are probably the best value investors you could imitate? Several fund managers follow the value investing style. However, each of them have their own definition for value. They may not agree on what is ‘good’ value.
For instance, one fund manager may follow a strategy where she picks stocks having strong fundamentals and trading at a big discount to their intrinsic value. For her, this is value investing. Another fund manager may pick stocks that are trading at a price that is lower than their peers. For this fund manager, this is value investing. As is obvious, both the managers seem to follow value investing. However, their definitions of value are pretty diverse and there is very little similarity in the way they pick stocks. That is one of the reasons why the performance of funds that follows value investing are different.
Want to know more about the different types of value investing? Here are the details.
Relative value investing
This is where fund managers compare a stock’s price ratios to that of a benchmark. These include ratios such as price to earnings (PE) ratio, price to book value (PBV) ratio and price to sales ratio.So, here the value will be about a standard or a benchmark. If a stock is trading at a value that is lower when compared to an index, it is considered to be undervalued by the fund manager. Note that the benchmarks can include the stock’s historical price ratios, an industry’s ratios or the markets.
Most often fund managers look at a stock that is trading at a price that is much lesser than other stocks in the same industry.However, it is important to ensure that the fundamentals of the company are strong.There are fund managers who think that the most popular benchmark used by value investors is the market or the broad market index. The stock of a company with strong fundamentaWlsmay fall because the industry in which it is functioning is going through a bad phase. However, the broad market depends on many factors and may not fall as sharply as a single stock.
Absolute value investing
This is where investors don’t compare a stock’s price to a standard. Rather, they try to analyse and find out a company’s worth in absolute terms. They will buy the stock if it is trading at a price that is lower than this absolute value. Absolute value can be ascertained using a variety of factors, such as the company’s assets, the strength of its balance sheet, Investors who have purchased the stock and revenue prospects as opposed to peers.
How to pick value stocks/funds during market correction?
Now that the markets have corrected significantly and a substantial amount of stocks and funds are available at a discount, here’s how to pick value stocks/funds.
Focus on fundamentals
The most important thing is to look at the workings of the company or if you are investing in a mutual fund, look at how the fund is run. Evaluating value investments based on the stock/fund’s underlying strengths and weaknesses will help you pick true value investments. For instance, find out about its management team, business model, cash flows, assets, liabilities and the demand for its products/services, both in and out of a recession.Do some research to see how specific they have performed during previous recessionary periods. If you are looking for income, consider the stability of dividend-paying value stocks/funds. If the stock/fund has maintained or increased its dividend during previous recessions, that’s a good sign.
Hedge against the volatility
Even though value stocks/funds can reduce the volatility of your portfolio, investors should hedge their risks. So, do not overpay for a rupee of earnings or cash flow and look for cash-rich companies with minimal debt. Choosing large-cap stocks/funds could also give you an edge if they have the financial flexibility to remain solvent during an economic downturn.
Choosing the right sectors to find value is also important. Many of the stock that are value buys are found in defensive sectors, such as consumer staples, utilities and telecom. These sectors could be a natural choice for value investing during a recession as they cater to consumers’ essential needs.
Avoid value traps
When a stock/fund appears to be undervalued turns and turns out to not be so, it is a value trap. For instance, a stock could have a low price-earnings ratio, low price-to-book ratio or a high-yield dividend. However, its performance could have plateaued.Value traps can be costly if you are looking to buy stocks at a discount during a recession. So, it’s important not to get caught in one.
Don’t know how to pick value mutual funds? Reach out to Mymoneysage.