Anyone who has ever read about Warren Buffett has more than likely come across the topic of value investing. This article dives deeper into the topic, examining the value-based approach in greater detail and to whom it might appeal.
What is Value Investing?
In its most basic form, value investing is the idea that you can make a profit in the market by buying relatively low-priced securities and selling them after they have appreciated in price. Put another way, a value investor seeks to find securities trading at a “bargain” price, meaning they are relatively cheaper than their industry peers and/or the broader market as a whole.
Outside of the investing realm, a value-based strategy could be synonymous with buying a used car that might need some work for a cheaper price versus paying a premium for a new, top-of-the-line model.
By comparison, growth stocks are securities that trade at a relatively higher price than their industry peers and/or the broader market. As such, “growth stocks” are known for trading at higher price-to-earnings ratios (P/E) than their “value” counterparts.
Because of this, value investing is inherently different from growth investing. The latter aims to profit from a continuation of an existing price trend, whereas value investing aims to capture a trend reversal – that is, buying a security when it is relatively inexpensive and selling it when its price reverts to a higher level.
Learn more about what momentum investing entails.
Value Investing Misconceptions
Value investing seems supportive of “going against the trend,” which we’ve all been taught is a losing strategy in financial markets. It is because of this misconception that many investors are hesitant to embrace this type of approach.
Perhaps the two most common – and false – assumptions about value investing are:
- Too risky – Most assume value investing is a losing game because it is inherently difficult to stomach the thought of buying a security that is not trending higher in price. In other words, it’s simply “too risky” to buy “bargain” stocks; the assumption being that cheap stocks are cheap for a good reason.
- Returns are paltry – Most associate value investing with paltry returns when compared to a growth, or momentum-focused strategy. While this may be true in the near-term, it’s far from reality over the long haul as evidenced by the historical returns profiled below.
All in all, many assume value investing to be either too boring or simply not worth their time.
The Appeal of Value Investing
There is a plethora of academic evidence supporting the merit of value investing. In fact, value investing has a deep history rooted in the work of Wall Street legends such as Benjamin Graham, who is regarded as the “Father of Value Investing,” and his extremely successful disciple, Warren Buffett.
To put its appeal into perspective, consider the following research from Fidelity on comparing the results of value and growth stock market indexes. This research looks at the historical “value premium” across various market-cap sizes; that is, the excess returns value stocks have generated over their growth counterparts. Consider the following visualization of these findings by Managed Asset Portfolios:
The key takeaway here is simple: The frequency of the value premium increases as the length of the investing period increases. Put another way, the odds that value stocks will outperform growth ones increases as your investment time horizon increases for securities of all sizes. So the assumption that value investing takes more time than growth investing to see results actually is on point – although not necessarily always true.
How Do Value ETFs Work?
In their most basic form, value-based ETFs are not at all complicated investment vehicles. You start with a broad-based index, such as the S&P 500 Index for example, and refine it down so you’re left with the securities exhibiting the strongest value characteristics. Some common “value screening” criteria, based on the teachings of Ben Graham, includes:
- Stock price is below book value per share
- Total debt is less than the stock’s book value
- Current ratio is greater than 2
- P/E ratio is less than 40% of the highest P/E ratio that stock has had over last five years
Once you have narrowed down a list of screening criteria, it’s time to refine the portfolio. You can do this by ranking each of the 500 stocks based on the value metrics you selected, then constructing a concentrated portfolio consisting of only the top 100 ranked stocks.
Ways to Play
Investors have dozens of options at their fingertips when it comes to pursuing a value-based strategy in the ETF wrapper. Consider the following:
- See All Value ETFs
- See Low P/E ETFs
Investors also can segment their product selection by market-cap size:
The Bottom Line
Don’t be quick to dismiss value-based ETFs because of preconceived notions about this strategy. Take the time to read about value investing to uncover whether this approach is right for you. While it has proven to generate outsized returns over growth investing, as the data indicates, this approach requires a long-term horizon for more successful implementation.
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