Value Investing

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Features of Value Shares

Some key valuation metrics can be used to determine the intrinsic value of a stock. A stock selection process requires not only financial analysis, but also consideration of fundamental factors such as the business model, brand, and competitive advantage. In this regard, it may be helpful to consider the following features:
 

• The price-to-book ratio (P/B ratio) or book value, which measures the value of a company's assets and compares it with the share price. A company is considered undervalued if the share price is lower than the asset value, provided that the company is not experiencing financial difficulties.
• The price-earnings ratio (P/E ratio), which shows the relationship between the company's earnings performance and the share price to determine whether the share price reflects total earnings or the stock is undervalued.
• Free Cash Flow (FCF): Free cash flow allows companies to invest in the future, pay the debt, pay dividends, and buy back shares.
• A company's debt-to-equity ratio measures how much of its assets are financed by debt.
• Shares bought and sold by insiders: Insiders (for example, employees) often buy shares when the company is performing well.
• Earnings Reports

Of course, there are many other key figures and factors that may be considered in such an analysis (e.g. equity, sales and earnings growth).

What Causes Stocks to be Undervalued or Overvalued?

Value investors partially reject the efficient markets hypothesis. The efficient markets hypothesis states that stock prices already take into account all information about a company, so that the price always reflects the value. Value investors believe that stocks can be overvalued or undervalued in the short term for a variety of reasons. Benjamin Graham believed in the efficient markets theory. Graham, however, argues that investor irrationality and other factors can lead to human error, such as the inability to predict the future. This means that fluctuations in the stock market always present an opportunity for investors to buy undervalued or unpopular stocks, thereby providing them with a margin of safety between the price paid per share and its intrinsic value.

In general, value investors behave in a contrary or countercyclical manner to other investors. Trending stocks are generally not bought by value investors. As long as the valuation metrics are accurate, they prefer to invest in unknown companies. In the event that the price of a well-known stock drops, value investors analyze the stock because they believe that the fundamentals of such companies will allow the company to recover from any price drop.

A share may trade at a discount to its intrinsic value for a variety of reasons. The most common cause of a share price decline is short-term earnings disappointment, which often results in a significant drop in the share price. Often, these disappointments can result in strong emotional reactions among shareholders, who sell their shares out of fear of further negative developments. The value investor recognizes two things: first, most companies are long-term oriented, and short-term declines in earnings do not negatively affect the value of a company over the long term. Second, they are aware that, on average, most corporate earnings reverse over time, which means catastrophic earnings declines are often offset over time, whereas extremely strong earnings growth is slower over time.

Investors often sell shares for emotional reasons, i.e. in panic and for irrational reasons. Markets may overreact to positive and negative news, causing price movements that are unrelated to long-term fundamentals of a company. Several factors may contribute to the undervaluation of a stock, including the following:

• Market movements and herd mentality: People sometimes invest irrationally without considering market fundamentals or factual information. In contrast, loss aversion causes investors to sell their shares when a stock's price declines or the overall market declines.
• Market crashes: A bubble usually develops when the market reaches a high far above average. In the event that a high cannot be sustained, investors panic, leading to a massive sell-off. This leads to a market collapse (e.g., the dot-com bubble).
• Unnoticed and unknown stocks: It is possible that some stocks are undervalued because investors and analysts are unaware of their existence.
• Bad news: Investors often sell their shares in response to bad news, despite the company's fundamental value.
• Cyclicality: All companies are affected by the business cycle (e.g. seasonality), which can affect the current profit level and share price, but not the long-term value of the company.

Risks of Value Investing

• Misinterpretation of financial reports: If financial reports and ratios are calculated and analyzed incorrectly, there is the risk of a bad investment, known as the value trap. When analyzing the financial reports, it is important to consider all factors, including accounting practices.
• The analysis may not take into account unusual gains or losses in the income statement, which could lead to a misinterpretation of the results. Extraordinary gains or losses are caused, for example, by litigation, restructuring or even natural disasters.
• Calculation of the valuation metrics/key figures: Valuation metrics can be calculated using pre-tax or after-tax figures. The results of some valuation metrics cannot be accurately predicted, but can be estimated. Earnings per share (EPS) may differ depending on how profit is defined. The use of different accounting practices makes it difficult to compare the ratios of different companies.
• Buying overvalued stocks: An important risk for value investors is investing in overvalued stocks. There is a possibility of losing some or all (bankruptcy) of the money invested if too much is paid, or if a stock is bought at a price close to its fair market value. Buying a stock that is undervalued reduces the risk of losing money, even if the company does not perform well.
• The lack of diversification is a risk in value investing that should not be underestimated. Value investors often invest when stock prices fall, and they prefer to do so in a staggered manner. In any case, it is possible that the price continues to decline and value investors continue to buy, in order to lower the average price. As a result, individual positions can become very large, which increases the risk associated with the individual stock and can decrease the portfolio's diversification.

The best way to minimize these risks is to consult an expert in the field of value investing, such as an experienced, independent wealth manager.

Value Investing vs. Growth Investing

Value stocks differ from growth stocks. Value investors look for stocks trading below their intrinsic value or book value, while growth investors consider a company's fundamental value but tend to ignore standard indicators that may suggest the stock is overvalued.

Value investors look for stocks that are trading below their intrinsic value, whereas growth investors focus on a company's future potential. Unlike value investors, growth investors may buy shares of companies trading above their current intrinsic value on the assumption that intrinsic value will increase and eventually exceed current valuations.

In order to diversify their portfolio, some investors include both growth stocks and value stocks. Others prefer to specialize by focusing on value- or growth stocks. The two investment styles do not necessarily have to contradict each other, because cheaply valued companies may demonstrate exceptional growth in the future. It is even possible to achieve extreme profitability by combining value with growth, but it can be extremely challenging to accomplish. For this reason, it can be beneficial to consult a specialist because a good wealth manager is capable of accurately identifying companies of this type through appropriate analysis.