It should be simple enough to make money on the stock market. Just buy stocks that are going to go up in value and sell them when they have reached their peak price.
In practice, this is of course impossible. No one can see the future. So, you can’t be certain that a particular stock will go up. Equally, you have no way of telling when your stock has reached its peak, and that it’s time to sell. The old adage that no-one rings a bell at the peak of the market is unfortunately true.
Value investing, however, attempts to do the next best thing.
How does it work?
It sounds simple enough. Investors actively seek out stocks they believe the market has undervalued and so trade for less than their intrinsic values.
In the long run, buying cheap stocks and holding them until they are expensive can tend to pay off, but there are some problems, not least that the technique has not worked very well in recent years.
The principle seems logical enough. Invest in stable, established companies who are nevertheless temporarily out of fashion, and which have a share price well below where an appraisal of their real value suggests it should be. When their fortunes start to change, and perhaps when other investors recognise them as a bargain they’ll go from being priced as losers to being winners, something that every investor will want in their portfolio.
In theory at least, these companies will deliver exciting and rapid capital growth.
Finding undervalued companies
The problem is still spotting the underdog before they start winning, and knowing when to sell.
Some value investors make their assessment on assets and earning. Others base their strategies completely on their estimation of future growth and cashflows. Whatever the signs they follow, they are looking for stocks with lower than average price-to-book and price-to-earnings ratios and higher than average dividend yields. It means wading through financial statements and analyses to identify cases where the market has mispriced stocks. This can be bewildering if you are not an expert. Even if you are, estimating the intrinsic value of a stock is difficult. Two investors can place a very different value on a company. Value investors need to buy an equity at a big enough discount to allow a margin of safety.
Whatever approach you take you will need to spend hours doing research to find companies that provide steady returns with stable dividends, which can suggest that the stocks they issue are undervalued.
In theory these stocks should do badly in downturns, and then enjoy a rally when the recovery phase arrives.
The trouble is, that in the wake of the 2008 financial crisis, the recovery hasn’t really come for many of these companies. It may be that they have lost the market position they once had, or the fact that growth stocks – particularly those in the technology sector – have become more attractive. It may be unjust, and it is probably irrational, but in the current markets, undervalued stocks may be destined to stay that way.
What should you do?
Value investing is one of several techniques that investors may try to beat the market, but none can guarantee results. A better approach may be to maximise your time in the market, get a good spread of shares and make regular investments. It can appear unexciting, but for the long term it can produce results that are hard to beat.
If you are ready to discuss investing, at Continuum we are ready to help.
The value of investments can fall as well as rise and you may get back less than you invested.