Value Investing Trading Strategy: Meaning, How to Use & Examples

Value investing is a trading strategy that involves identifying and buying undervalued stocks or assets. Value investors focus on buying stocks that are trading below their intrinsic value, based on factors like financial analysis, business fundamentals, and market conditions. The goal is to find opportunities where the market has underestimated the true value of a company, with the expectation that the stock price will eventually rise to reflect its actual value.

There are many well-known value investors, with Warren Buffett the best-known.

Others include Benjamin Graham (Buffett’s professor and mentor), David Dodd, and Charlie Munger (Buffet’s business partner).

In this article, we’ll have a look at the value investing trading strategy, how it’s used as well as a historical example.

Understanding value investing trading strategy

The basic concept behind everyday value investing is simple. If you know the real value of something, you can save a lot of money when you buy it. Most people would agree that whether you buy a new TV on sale, or at full price, you will get the same TV with the same screen size and picture quality.

Stock prices work in the same way, where a company’s share price may change even when the company’s valuation has stayed the same. A true, or intrinsic value, of the stock of a given company does not exist, but there are relative values.

Intrinsic value and value investing

Various metrics are used to find the valuation or intrinsic value of a stock. Intrinsic value is a combination of using financial analysis, such as studying a company’s financial performance, revenue, earnings, cash flow, profit, and fundamental factors.

It includes the company’s brand, business model, target market, and competitive advantage.

Some metrics used to value a company’s stock include:

• Price-to-book (P/B): this measures the value of a company’s assets and compares them to the stock price.

• Price-to-earnings (P/E): this shows the company’s track record for earnings to determine if the stock price is not reflecting all of the earnings or is undervalued.

• Free cash flow: this is the cash generated from a company’s revenue or operations after the costs of expenditures have been subtracted.

There are many other metrics used in the analysis, including analyzing debt, equity, sales, and revenue growth.

Value investors set a margin of safety

Value investors often set their own “margin of safety” as this allows for a margin of error. This principle is based on the idea that buying stocks at bargain prices increases the chance of earning a profit later when you sell them. The margin of safety also reduces the risk of loss if the stock performs below expectations.

For example, if you believe a stock’s value is $100 and buy it for $66, you’ll make a profit of $34 by waiting for the stock’s price to rise to its true value. In addition, the company might grow and become more valuable, offering more profit opportunities. On the other hand, if the stock’s price rises to $110, you’ll make $44 since you bought the stock on sale. If you had bought it at its full price of $100, you would only make a $10 profit.

Value investors consider the markets to be inefficient

Value investors reject the efficient-market hypothesis, which says that stock prices already take all information about a company into account, so their price always reflects their value. Instead, value investors believe that stocks may be over or underpriced for different reasons.

For example, a stock might be underpriced because the economy is not performing well, and investors are panicking and selling (as was the case during the Great Depression). Or a stock might be overpriced because investors have become too excited about an unproven new technology (as was the case of the dot-com bubble).

Psychological biases can also influence stock prices, driven by news, such as disappointing or unexpected earnings announcements, product recalls, or litigation. Additionally, stocks may be undervalued because they trade under the radar, meaning analysts and the media inadequately cover them.

Value investors don’t follow the herd

Value investors don’t follow the herd. While others are buying, they may opt to sell or stand back. On the other hand, when everyone else is selling, they’re buying or holding. They avoid trendy stocks as they’re usually overpriced. Rather, they invest in companies that aren’t household names if the financials check out. They also re-evaluate stocks that are household names when those stocks’ prices have experienced significant price drops, believing in the potential of these companies if their fundamentals remain strong and their products and services still have quality.

Value investors are concerned only about a stock’s intrinsic value. They think about buying a stock for a percentage of ownership in a company. They prioritise companies that have sound principles and financials, regardless of what everyone else is saying or doing.

Value investing demands diligence and patience

Estimating the true intrinsic value of a stock involves some financial analysis but also a fair amount of subjectivity. Two different investors can analyze identical valuation data on a company and arrive at contrasting decisions. Therefore, you’ll need to develop a strategy that works for you.

Choose a preferred method

Some value investors focus only on existing financials, while others focus primarily on a company’s future growth potential and estimated cash flows. Some investors use a combination of both approaches.

Buy for less

The underlying logic of value investing trading strategy is to buy assets for less than they are currently worth, holding them for the long-term, and profiting when they return to their intrinsic value or above. 

Play the waiting game

Like all investment strategies, you need to have the patience and diligence to stick with your investment philosophy. While some stocks may seem attractive due to solid fundamentals, you’ll need patience if they’re overpriced. You’ll want to buy the stock that is most attractively priced at that moment, even if it means holding cash until such opportunities arise.

Value investing trading strategies

The key to purchasing an undervalued stock is to thoroughly research the company and make informed, common-sense decisions. Well-known value investor Christopher H. Browne recommends asking whether a company is likely to increase its revenue through several methods:

• Raising prices on products
• Increasing sales figures
• Decreasing expenses
• Selling off or closing down unprofitable divisions

Browne also recommends studying a company’s competitors to gauge its future growth prospects. 

Warren Buffett recommends investing only in industries where you have personal experience or familiarity with consumer goods, like cars, clothes, appliances, and food.

One strategy available is to choose the stocks of companies that sell high-demand products and services. While it’s difficult to predict when innovative new products will capture market share, it’s relatively easy to work out how long a company has been in business and study how it has adapted to challenges over time.

Insider buying and selling

Insider buying and selling refer to transactions involving a company’s senior managers, directors, and shareholders who own at least 10% of the company’s stock. A company’s managers and directors have unique insights into the company’s operations, so if they are purchasing its stock, it’s reasonable to assume that the company’s prospects look favourable.

Similarly, investors who own at least 10% of a company’s stock wouldn’t have bought such a big share if they didn’t see profit potential. Conversely, insider stock sales do not necessarily indicate bad news about the company’s future performance. Insiders may sell shares for a number of personal reasons. However, if there are mass sell-offs by insiders, such a situation may need further in-depth analysis of the reason behind the sale.

Value investing in trading strategies and financial reports

At some point, value investors must look at a company’s financials to see how it’s performing and compare it to industry peers.

Financial reports, namely the annual report and the quarterly report, provide detailed insights into a company’s performance on an annual and quarterly basis. Companies are required to file these reports with the Securities and Exchange Commission (SEC).

A historical example of a value investment

Value investors aim to capitalise on market overreactions that usually come from the release of a quarterly earnings report. A historical example occurred on May 4, 2016, when Fitbit released its Q1 2016 earnings report, resulting in a sharp decline in after-hours trading. The company’s value plummeted by nearly 19%. Regardless of this downturn, Fitbit met analyst expectations for the quarter and increased guidance for 2016.

During the first quarter of 2016, Fitbit reported revenue of $505.4 million, an increase of more than 50% compared to the same time period from the previous year. Further, in Q2 of 2016 Fitbit expected to generate between $565 million and $585 million, which was above the $531 million forecasted by analysts.

Despite showing strength and growth, Fitbit’s earning per share (EPS) declined compared to the previous year due to heavy investment in research and development. This decline made investors sell off enough shares, causing the price to fall. However, a value investor who looked at the fundamentals of Fitbit understood it was an undervalued security with potential for future growth.

Indeed, in the following years Fitbit’s revenues soared, exceeding $1.4 billion in 2019. In 2021, Google finalised its acquisition of Fitbit for $2.1 billion. A value investor who purchased Fitbit stock at an undervalued price of $5.35 on Feb. 9, 2017, would have made a good profit as the stocks were converted to cash at a value of $7.35 per share at the merger and paid out to investors.

Final thoughts about value investing

Value investing is a long-term trading strategy. For example, Warren Buffett buys stocks to hold them for long periods. He once said, “I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years.”

While there may be a time when you need to sell your stocks to make a major purchase or retire, by diversifying your portfolio and maintaining a long-term outlook, you can aim to sell your stocks only when their price exceeds their fair market value (and the price you paid for them).

Disclaimer:
This information is not considered investment advice or an investment recommendation, but instead a marketing communication. IronFX is not responsible for any data or information provided by third parties referenced or hyperlinked in this communication.