Value Investing
There is no universal definition for value investing. One thing value fund managers have in common is they are looking for stocks believed to be worth moderately or significantly more than their current share price. How a manager defines value will determine the portfolio and, ultimately, its performance. There are years when some value funds have high double-digit returns while others have negative returns, even though all of the value funds may be small, mid, or large cap.
The two major types of value investing are relative-value and absolute-value. A relative-value investor compares a stock’s price ratios (e.g., P/E, P/B, and price-to-sales) with a category benchmark and then makes a decision about the future prospects. The benchmarks used can include one or more of the following:
- Historical Stock Price Ratios—Companies selling for lower than usual ratios may signal an attractive buy. The low selling price may be due to bad news.
- Stock’s Industry or Sector—Companies whose stock a fund manager believes is selling at an undeservedly cheap price compared with its competitors.
- Market—Companies attractively valued when compared with a broad market, such as the S&P 500 or Wilshire 5000; circumstances unique to a company that have caused its share price to drop or a company in a currently out-of-favor industry group (common with cyclical sectors such as industrials).
In general, relative-value funds have a decent shot of delivering strong performance in a variety of market conditions—not just when truly cheap stocks are in demand. The key drawback to the relative-value approach is these funds might also have more exposure to volatile sectors, with telecommunications and technology being prime examples.
The “absolute-value” approach prices the entire company, using its assets, balance sheet, cash flow, and expected future earnings. Managers who practice the absolute-value method will also look at what private investors have paid for similar companies.
Absolute-value managers do not compare a stock’s price ratios with historic norms, those of other companies, or the market. Instead, they try to figure out what a company is truly worth, and they want to pay substantially less than for the stock. If it is not selling for substantially less, they are simply not interested, even if the stock is selling at a lower price than all of its rivals or the average for the S&P 500.
As a general rule, absolute-value managers often focus on companies in traditional value sectors, including financial firms, basic material, and manufacturing companies as well as energy firms. But some of these funds also venture into traditional growth sectors—including technology, health care, and retail.
Absolute-value managers may be willing to make more dramatic sector bets than their relative-value counterparts. Some absolute-value managers have also bought inexpensive stocks that have stayed depressed. That problem—also known as the value trap—illustrates one of the key dangers of investing in cheap stocks: You may be buying cheap stocks that get cheaper.
Whether the fund is relative-value or absolute-value based, the average price multiples of the portfolio will show if the manager is acquiring stocks that are more or less expensive than other category offerings. Average price multiples can be found in shareholder reports.
Selling Value
A value manager will sell a stock because it: (1) is no longer considered a bargain, or (2) picking the stock turned out to be a mistake. Once a stock becomes fairly valued, by whatever measurements the fund uses, it is considered a strong “sell” candidate. In other cases, the stock may now look less promising than it did originally, causing management to reassess the holding.
Although value funds generally show less volatility than growth funds, this does not guarantee safety. In many previous market downturns, such as the cyclicals and financials’ decline of 1990, the utilities debacle of 1994, Asian crisis of 1998, and the 2008 meltdown, value funds lost as much or more money than growth funds.