Warren Buffett is a great investor.
His strategy was once described as follows: “Whether we are talking about socks, stocks, or both, I like to buy quality merchandise when it’s marked down.”
Buffett’s approach to the stock exchange that involves bargain hunting is often called value investing. This strategy has been studied and practiced by investors for almost a century.
Despite Buffett’s success, value investment has had mixed results in recent decades. Histories show that value stocks lag behind other types of stocks in the 1990s and the latter part of 2010.
However, experts think that this is changing with today’s rising interest rates.
What’s value investing?
Value investing simply means that you buy stocks that you believe are more valuable than the current market price.
Value stocks are companies with share prices that are lower than what they “should”, as measured by fundamental financial metrics like earnings per share.
Value investing involves buying stocks that aren’t in demand by investors in the hope of seeing a rebound in share prices.
Value stocks often are contrasted to value stocks , which appeals to investors who want rapid growth in their earnings or revenue.
Value stocks generally have stronger fundamentals than growth stocks, says Michael Chomiak (an investment manager at Access Wealth in East Hanover. New Jersey).
He says that these businesses are usually older and more stable, with steady dividends and free cash flow.
Value investing is more long-term-oriented because it focuses on solid fundamentals and comeback stories. Buffett once said that his favorite period for holding is “forever .'”
Chomiak is in agreement. Chomiak agrees.
How can you find value stocks?
Value investors look at a number of metrics when identifying bargain-price stocks. Chomiak states that the price to earnings ratio (or PE ratio) is the most important.
The PE ratio of a stock is the sum of its share price and its earnings per share for the past 12 months. He says, “The higher the number is, the more expensive [stock] would become.”
Chomiak states that value investors tend to look for stocks with PE Ratios below 14. This is slightly less than the historical average PE ratio 15.98 of the S&P 500.
He said that positive cash flow, which is another indicator of profitability, is another thing to look at when trying to identify value companies.
“Positive Cash Flows give them the opportunity reinvest into the business, do buybacks and increase dividends,” Chomiak states.
Low debt-to-equity and high return on equity are two other signals value investors seek. These metrics can all be found on an online stock screener or on Yahoo Finance.
Do rising interest rates benefit value investors?
The historical data shows that value investing is especially profitable when interest rates rise — and they are currently rising. This year, the Federal Reserve increased the federal funds rates six times.
“This is the right time to invest in value stocks. Chomiak states that as interest rates rise, capital costs will become more expensive. Chomiak states that growth companies typically borrow at a higher level than value businesses.
“The value trade is gaining momentum and this is a good thing. He says it’s safer to trade in volatile times.
However, Dartmouth College finance professor Kenneth French stated in an email interview that interest rates can have an impact on value investing returns.
A 2020 paper by Eugene Fama, a French and University of Chicago professor, compared returns of value stocks to those of the entire market between July 1963 and June 2019
The first half of their study period, 1963-1991, showed that value stocks outperformed the market. This advantage vanished in the second half, 1991 to 2019.
The benchmark interest rate of the Federal Reserve was twice as high as the average in the period 1963-1991 than in the period 1991-1999. In the first period, the federal funds rate was in an upward trend while it was in the second in a long term downward trend.
French however stated that his research does not prove a connection between these two things.
He said that it was impossible to tell if the value-investing returns have changed by chance or if there has been a fundamental shift in the economic environment.
When should you begin looking for value stocks?
Your investment goals and time availability will determine whether or not you should make an investment in value stocks. Value investors are bargain hunters that use metrics such as PE ratio and free liquidity to find cheap stocks with long-term prospects.
This type of investing requires a lot more research and time. This type of investing often involves buying individual stocks which can be expensive.
Advisors believe that rising interest rates could boost value stocks. The relative performance of value stock seems to be related with interest rates. Researchers aren’t certain if there is a causal link between the two.
Beginners should be aware that, regardless of whether we are heading into a value investing revival, it can take a lot work and money to get the strategy right.
Index funds could offer steady returns with lower maintenance costs and a lower upfront price.