Many people familiar with the stock market know about the idea of ‘growth’ and ‘value’ stocks. Growth stocks are those that are expected to outpace the market, while value stocks are those that trade at a low price relative to its level of sales or earnings. While the two may sound similar, the value investment philosophy is much different than the idea of value stocks.
Value investing is not limited to certain stocks, and definitely isn’t restrained by arbitrary valuation ratios. Value investing can apply to any stock as long as you are getting a ‘deal’ when you buy it. Just like you would shop around for the best price before making a large purchase, value investors will only buy companies that they feel are cheap relative to their actual value. Stocks, just like other things you buy, experience times of higher and lower demand which causes their prices to change.
This idea requires the belief that participants in the stock market do not consider properly all factors when pricing stocks, especially in the short-run. Events such as The Great Recession drive down prices as a weakening economy causes investors to panic and sell all stocks indiscriminately, even those that represent fundamentally sound businesses. This creates a buying opportunity for value investors. During booming bull markets such as the dot-com bubble, investors become overly optimistic and eagerly buy stocks, driving prices higher than what they are actually worth. Value investors see this and either sell their shares, or at the very least refrain from buying.
This philosophy requires great diligence and adherence to a strict discipline. To buy when others are frenziedly selling, and sell when others can’t buy fast enough is easier said than done. This is a long-term investment philosophy and the process requires great patience. Positions will occasionally lose money in the short-run as others engage in panic selling, but for investors who are bargain hunters are looking for prices to recover over time. There will also be times when you wish to purchase stock in a fundamentally sound company, but end up sitting on the sideline because the price is unjustifiably high at the moment. In some extremes, no companies may be well priced, and you may have to just wait it out in cash.
All of this sounds very simple in theory; just buy low and sell high. Finding these stocks, however, is no easy task. In order to tell if a stock is cheap, you have to know its actual worth. This is not as informal as simply looking at a stock quote; if everyone knew the stock’s true value, everyone would buy it, driving the price up, and it would no longer be cheap. Value investors must be willing to put in the time and effort to dig through a company’s financials, understand its products, and be able to identify its prospects for the future.