Value investing targets stocks trading below their intrinsic worth based on fundamentals like earnings, book value, or cash flow. It’s one of the oldest and most researched investment approaches.
Beginner
What It Means
Value investing is about buying stocks that are “on sale” - companies trading at low prices relative to their fundamentals. The idea is simple: if a company is worth $100 but trades at $60, buying it should eventually pay off when the market recognizes its true value.
Portfolio Example
Company A trades at $40 per share but analysis suggests it’s worth $60 based on its assets, earnings, and cash flows. A value investor buys, expecting the price to rise toward $60 over time.
Classic Value Metrics
| Metric | What It Measures | ”Cheap” Means |
|---|
| P/E Ratio | Price vs. Earnings | Lower is cheaper |
| P/B Ratio | Price vs. Book Value | Lower is cheaper |
| EV/EBITDA | Enterprise Value vs. Cash Flow | Lower is cheaper |
| Dividend Yield | Dividends vs. Price | Higher is cheaper |
Why It Matters
Value investing has a long track record of success, championed by legendary investors like Benjamin Graham and Warren Buffett. Understanding value helps identify potentially underpriced opportunities.
Advanced
The Value Premium
Academic research documents that cheap stocks (by various measures) tend to outperform expensive stocks over time:
| Period | Value Premium (HML) |
|---|
| 1926-2023 | ~3-4% annually |
| 1963-2006 | ~5% annually |
| 2007-2020 | Near zero or negative |
Value significantly underperformed from 2007-2020, leading many to question whether the premium persists. The 2020s have seen some value recovery.
Why Value May Work
Risk-Based Explanations:
- Value stocks are riskier (distress risk, leverage)
- Higher returns compensate for higher risk
- Value stocks do worse in recessions
Behavioral Explanations:
- Investors overreact to bad news, pushing prices too low
- Glamour/growth stocks get overvalued due to excessive optimism
- Mean reversion in fundamentals isn’t fully priced
Value Metrics Deep Dive
| Metric | Pros | Cons |
|---|
| P/E | Simple, widely used | Earnings can be manipulated |
| P/B | Stable, hard to manipulate | Less relevant for asset-light businesses |
| EV/EBITDA | Accounts for debt | Ignores capex requirements |
| FCF Yield | Cash-based, hard to fake | Volatile year-to-year |
Modern Value Challenges
Traditional value metrics face challenges in the modern economy:
| Challenge | Issue |
|---|
| Intangibles | R&D, brand value not on balance sheet |
| Asset-Light Business | Tech companies have little book value |
| Low Interest Rates | Growth stocks benefited disproportionately |
| Winner-Take-All | Scale advantages make “cheap” stocks genuinely worse |
Value Traps
A value trap is a stock that looks cheap but deserves to be cheap - the low price reflects genuine problems, not market inefficiency.
- Declining industry (newspapers, retail)
- Persistent earnings deterioration
- Weak competitive position
- High debt with refinancing risk
- Management quality issues
Value vs. Growth
| Characteristic | Value | Growth |
|---|
| Valuation | Low P/E, P/B | High P/E, P/B |
| Expectations | Low, beaten down | High, optimistic |
| Risk Profile | Distress risk | Duration risk |
| Performance | Better in recoveries | Better in expansions |
Combining Value with Quality
Modern approaches combine value with quality screens:
Traditional Value: Buy cheapest stocks
Quality Value: Buy cheap stocks that are also profitable and stable
Adding quality filters helps avoid value traps
Historical Drawdowns
Value can underperform for extended periods:
| Period | Value vs. Growth |
|---|
| 1998-2000 | -60% (dot-com bubble) |
| 2017-2020 | -40% (growth dominance) |
Data Requirements
| Requirement | Details |
|---|
| Fundamental Data | Earnings, book value, cash flows |
| History | Quarterly updates, annual comparisons |
| Normalization | Adjust for cyclicality, one-time items |
