Methodology

Stocks

Module 3

What is unsystematic risk?

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Value investing

Value investing

Value investing involves buying stocks that appear to be under-valued in relation to their book value.

Value investor attempt to buy stocks that they think have been overlooked by the whole market, in hope that the potential of the company will be recognised and that the stock will become more popular.

If an investor becomes very skilled at identifying under-valued stocks, they can make huge capital gains.

The most famous investor in the world, Warren Buffett, famously uses a value investing strategy. He attempts to buy stocks that are not popular on the stock market, with the aim of buying it at a very low valuation.

It doesn’t always need to be the case that the stock is always unpopular, value investing could involve buying popular stocks that have fallen out of favour temporarily. 

For example, Warren Buffett invested heavily into Apple stock in 2016, when the company fell out of favour due to missing their earnings target for the year. Since then, Apple stock has increased from $30 to $150 per share (as of April 2022).

What value investors look for

In order to make money from value investing, it is necessary for investors to identify stocks that are undervalued.

A key way that value investors would do that is by using financial ratios, such as the p/e ratio or the p/b ratio – we already covered both of those in module 1 of this course.

When it comes to the p/e and p/b ratio of a stock, a value investor would attempt to identify a stock that has an abnormally low p/e or p/b ratio, when compared with other stocks in the same field.

In general, a value investor would consider stocks that have a very low p/e or p/b ratio.

For instance, when it comes to the p/e ratio, a value investor may consider a stock to be under-valued if it has a p/e ratio that is 3 or less.

When it comes to the p/b ratio, on the other hand, a value investor may consider a stock to be under-valued if it has a p/e ratio of less than 1 (the lower the number the better).

Value investing and risk

Value investing is only profitable if an under-valued stock eventually reaches a fair value again.

If this does not happen, then the stock may remain at the same price level or the stock price could even fall further. Therefore, it is important for value investors to identify reasons why the stock price of a stock may rise again.

The reasons why an under-valued stocks may rise again could be that the company has growing profits that have no been recognised, that the company is set to announce the launch of a new product or that the company set to turn around losses.

Unless an investor can identify potential reasons why an under-valued stock may increase in value, then it is not worth pursuing.

This is the case because an under-valued stock could be under-valued due to the fact that it has bad prospects for the future. It could be that the stock is in the decline phase and that it will be more less valuable over time.

Therefore, when using a value investing strategy, investors should analyse the business across multiple dimensions. For instance, reading the annual report of a company can provide a lot of useful insights into its future prospects.

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