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Talking Money: Value Investing

To foster financial literacy, we regularly feature discussions on common terms and concepts used in personal finance and investing. Here’s an article from Debi Rybicki on value investment strategy.  

Value investing is a time-proven successful investment strategy that allows investors to buy into companies whose stocks are underpriced, then reap the benefits as the true value of those companies is recognized and rewarded by the marketplace.

Value investors believe that the market overreacts to good and bad news that can result in stock price movements that do not correspond with a company’s long-term fundamentals, creating a temporary disparity between the fair value of the business and its current market price. The result is an opportunity for investors to profit by buying when the price is deflated.

While many traders and investors want excitement in their stocks, value investors want stocks that are unnoticed by the crowd and selling for less than they are worth. They believe that solid companies will continue to perform well and close the gap between their market price and fair value.

The value approach to money management was introduced in the 1930s by Benjamin Graham, a pioneer in stock analysis and widely considered the father of value investing. He was adamant that stocks provide a wide margin of safety after weighting the tradeoff between price and intrinsic value. Graham’s most famous disciple, Warren Buffett, is noted for his adherence to the value investing philosophy and is one of the richest men in the world.

Further reading:

Choosing Investments,” from the Financial Industry Regulatory Authority

Beginners’ Guide to Asset Allocation, Diversification, and Rebalancing,” from the U.S. Securities and Exchange Commission

Academic studies have found that over time not only do value stocks outperform growth stocks and the market as a whole, they also are more conservative.

By definition, value stocks have a low price-to-earnings ratio – a measure of the price per share relative to the annual profit earned per share. A higher P/E means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with a lower P/E. (As a point of reference, the historic median P/E for the Standard & Poor’s 500, which includes both value and growth stocks, is about 15.5)

Of course, value stocks also are subject to risk – even the possible loss of principal – as such factors as fundamental weakness in a company can depress the value of the stock.

Historically, stocks that pay dividends have outperformed those that don’t. And value stocks are more likely to pay dividends than growth stocks. The payment of regular dividends is a sure sign of financial viability. You can try to manipulate numbers on a balance sheet to mislead investors, but dividends must be paid in real money. Companies will go to great lengths and endure great hardships before cutting or omitting a dividend.

To recap, the benefits of value investing are:

• lower risk, especially compared to pure growth or other strategies

• reduced trading costs, since the concept is buy and hold – which can also lessen capital gains taxes

• and lower portfolio volatility.

Within a diversified investment portfolio set up for long-term results, value stocks – whether held individually or through mutual funds – can offer both growth and preservation to the patient investor.

initially posted June 14, 2012

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