Value investing is an investment discipline that was popularized by Benjamin Graham through his seminal books like Security Analysis published in 1934 and The Intelligent Investor in 1949. Value investing seeks to identify undervalued stocks that are trading below their intrinsic value, and buying and holding them until they turn around. Such value stocks typically trade at price-to-earnings (P/E) and price-to-book (P/B) multiples that are significantly below the valuations at which the market or their peers trade. While Warren Buffett has amassed a colossal fortune by adhering to the principles of value investing, there is little doubt that for us lesser mortals, value investing has its pitfalls in addition to its undeniable benefits. We discuss some of these pros and cons below.
Pros of Value Investing
- Potential for Spectacular Profits: Value investing offers the potential for spectacular profits, because the value investor seeks to buy the stock when it is trading at a discount to intrinsic value, and sell it when it is trading at or above intrinsic value. Stocks that can successfully turn around can generate exponential returns over time, as their earnings improve and they are accorded higher valuations by investors.
- Attractive Risk / Reward: Value stocks usually trade at fairly low valuations and may also have a low dollar price, which means that downside risk is capped. On the other hand, as noted earlier, the potential for spectacular profits exists, if the value investor has gauged the stock correctly. This combination makes for an attractive risk / reward payoff for a typical value stock.
- Based on Solid Research Rather Than Hot Tips: Value investing is based on determining a stock’s intrinsic value and its “margin of safety,” which is the downside cushion available to the value investor through the stock’s discounted valuation. This requires solid research to be conducted on a value stock, its peers, and the sector. Value investors are unlikely to find their stock candidates through hype or hot tips.
- Skewed Towards Blue Chips: The desired valuation metrics of a value stock such as a low P/E, low P/B, or above-average dividend yield, tilts the scales towards blue chips, which are generally safer than their smaller-cap counterparts.
- Early Participant in Turnaround: Value investors are usually the earliest participants in a stock that is turning around. This means that their entry price is likely to be significantly lower than that of other investors who are late to the party.
- Low Entry Price Enables Stock Volatility to be Absorbed: A low entry price also means that the value investor has the wherewithal to ride out volatility in the stock price because of a lower break-even point.
Cons of Value Investing
- Needs a Contrarian Approach: Value investing needs a contrarian approach or a proclivity to go “against the herd,” since one is wagering against the majority view that the stock is a basket case or near to becoming one. Adopting a contrarian viewpoint consistently is easier said than done.
- Risk of Being Caught in a “Value Trap”: If the majority view does turn out to be right with regard to a value stock, the value investor risks tying up his capital in a “value trap,” in which case he or she may have no choice but to exit the position at a significant loss. This is a major reason why value investing is often compared to “trying to catch a falling knife.”
- Huge Losses Can Result on Averaging Down: A mantra espoused by some value investors is “if you liked a stock at $20, you should love it at $10,” the implication being that one should average down on a value stock that continues to fall. This can often have disastrous consequences. A well-known example is that of star fund manager Bill Miller, whose stellar record of outperforming the S&P 500 for a 15-year period was tarnished when he loaded up on banks and financial institutions in 2008, resulting in his fund losing 58% over the 12-month period ended December 2008.
- May Miss Out on Hot Sectors: One of the hottest sectors in the bull market that commenced in March 2009 was the biotech sector, with the biggest biotech firms surging by an average of 500% over the next six years. The biotech sector would in most cases be anathema to a value investor because of its sky-high valuations. Value investors thus run the risk of missing out on hot sectors that can turbocharge portfolio performance.
- Portfolio Concentration: Value stocks may be clustered in sectors that are temporarily out of favor, as for instance bank stocks in 2009 or energy stocks in 2015. This may result in a value-oriented portfolio being concentrated in a few sectors, and thus being inadequately diversified.
- Difficult to Find Value Candidates in Big Bull Markets: It becomes increasingly difficult to identify good value candidates in a broad and long-running bull market, since most stocks may be trading at premium valuations. The value investor may therefore have to bide his or her time until there is more choice in the universe of value stocks.
- Lengthy Holding Periods: Value investing demands an ability to hold onto a stock for years, as it can take a great deal of time before there is a turnaround in a stock’s fortunes and investor sentiment for it.
The Bottom Line
Value investing has its advantages, but it also has significant drawbacks. Investors who are considering following this investment discipline should be cognizant of both.