If you want to add value investments to your diversified portfolio, then read on for valuable insights on buying value stocks
Buying value investments has natural appeal for those who grew up in strained economic circumstances.
However, too much reliance on value investing can cost you money as well.
Below are some tips for better value investing and ways to select top value stocks.
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Value investments and growth investing
Academic studies suggest that on average, value investing produces better results than growth investing. But these studies mostly look back on what would have happened in a particular historical period, if you followed a particular set of rules. Most distinguish between growth and income investing by looking at average p/e’s (per-share price-to-per-share earnings ratios). They assume high p/e’s are a marker for growth stocks and low p/e’s for value stocks. As any serious value or growth investor can tell you, it’s more complicated than that.
If you balance and diversify your portfolio as we recommend, it should include both growth and value selections. In both areas, you should avoid extremes.
If a stock seems like an exceptional bargain in relation to earnings or asset values, it may suffer from hidden risks. The stock can plunge when those problems begin to take their toll.
Value investments: Look beyond financial indicators
When they first set out to formulate a plan, many investors decide to base investment decisions on a handful of measures. For instance, they may want to see a p/e ratio (the ratio of a stock price to its per-share earnings) below 15.0, say, along with an earnings growth rate of 20% or more annually, and perhaps a 2% dividend yield.
This approach worked a lot better in the pre-computer age, when investing was more labour-intensive. Few people wanted to dig through old newspapers, annual reports and other material to get at the data. So more gems were left to be found by those willing to do the work.
In modern times, if you find a stock with this (or any comparable) combination of favourable ratios, it probably comes with some more-or-less hidden drawback not covered by your system. Instead of steering you away from investments that you don’t understand, or that harbour hidden risk, this system will steer you toward them.
Financial factors to look for in top value investments:
5 to 10 year history of profit. Companies that make money regularly are safer than chronic or even occasional money losers.
5 to 10 years of dividends. Companies can fake earnings, but dividends are cash outlays. If you only buy dividend-paying value stock picks, you’ll avoid most frauds.
Manageable debt. When bad times hit, debt-heavy companies go broke first.
Safety factors to identify while looking for top value investments:
Industry prominence if not dominance. Major companies can influence legislation, industry trends and other business factors to suit themselves. Minor firms, on the other hand, don’t have that power.
Geographical diversification. Canada-wide is good, multinational better. There’s extra risk in firms confined to one geographical area.
Freedom to serve (all) shareholders. High-quality value stock picks must be free of excess regulation, free of dependence on a single customer, and free from self-dealing insiders or parent companies.
These 3 financial ratios are useful in spotting value investments:
Price-earnings ratios: The p/e is the ratio of a stock’s market price to its per-share earnings.
Price-to-book-value ratios: The book value per share of a company is the value that the company’s books place on its assets, less all liabilities, divided by the number of shares outstanding.
Price-cash flow ratios: Cash flow is essentially earnings without factoring in non-cash charges such as depreciation, depletion or the write-off of asset values.
When you look for stocks that are undervalued, it’s best to focus on shares of quality companies that have a consistent history of sales and earnings, as well as a strong hold on a growing clientele.
Our goal is to put the information in a form that lets us weed out the extremes—excessively overvalued stocks, or those that are suspiciously cheap. In the long run, investors make most of their profits in investments that offer good value and an attractive long-term outlook.
Are you currently holding value investments? How have they performed for you? Share your story with us in the comments.
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