We all love a good deal — and value investors believe there are plenty of them to be found in the stock market.
Value investing is a strategy made famous by iconic investors like Benjamin Graham and Warren Buffett. Practitioners aim to identify stocks whose prices don’t reflect what they’re really worth. Their hope is that when the market grasps these stocks’ true value, share prices will shoot up. “It’s kind of like looking for buried treasure,” says financial advisor Stephanie Roberts, in Albany, N.Y.
Like hunting for treasure, value investing requires plenty of research, legwork and patience. Identifying value stocks means poring over wonky measures like price-to-book ratios and price-to-earnings ratios. And while value stocks have tended to outperform more-expensive, faster-growing growth stocks, they often lag for years at a time. Still, even if you aren’t interested in picking stocks yourself, there are plenty of mutual funds and ETFs that can help follow the strategy for you.
Here’s what you need to know to get started as a value investor.
Value vs. growth stocks
Investors and analysts have long broken the stock market into two main categories — growth stocks and value stocks. Growth companies are expected to generate revenue and profits faster than their industry or the overall market. Investors buy growth stocks in anticipation of future profits, in many cases when the companies haven’t yet broken even. A recent example of a growth stock is Tesla, the maker of electric vehicles and renewable energy solutions.
Value stocks typically lack the hype that can drive up their growth counterparts. They tend to operate in mature industries, producing goods and services that are on the practical side. “Value investing is more focused on companies that are well established and are delivering stable revenues and consistent profits,” says Roberts.
A good example is IBM, which provides services like data management and cybersecurity for businesses and is known for its steady earnings and dividends. A hype deficit is one reason such stocks might be temporarily undervalued. Negative news might also overshadow their long-term prospects and drive down their stock price. And genuine trouble at one company can unduly depress prices across the entire industry.
Practitioners of value investing identify stocks whose prices fall short of their intrinsic value and long-term growth potential. (More on how to gauge those things below.) Their hope is that when the market grasps these stocks’ true value, they’ll get a nice performance bump. In the meantime, investors often collect the dividend, which investing pros call getting paid to wait. Buying at a discount also cushions investors’ losses if the pick doesn’t pan out.
How do value stocks perform
How does value stocks’ performance stack up against that of growth stocks? It depends on the time period in question. Value dominated growth from about 1970 through the late 2000s, but then the tables turned. From 2011 through 2021, the Wilshire U.S. Large-Cap Growth Index had an annualized total return of 16%, versus the Wilshire U.S. Large-Cap Value Index’s 10%. In 2022, amid inflation and recession fears, the value index crushed its counterpart, as it fell just 8% compared with a 30% loss for growth. But in 2023 the growth index is back on top: It’s returned 31% while value has eked out a 1.3% gain.
The fortunes of value and growth are influenced by economic factors: Lower interest rates tend to favor growth, while value stocks often shine amid rising rates. That’s one reason “we’re actually in a more favorable environment, in theory, for value investing right now,” says Roberts.
Time will tell if that’s the case. But there’s a strong argument for including both growth and value stocks in a portfolio: Over shorter periods, value should shine when growth struggles, and vice versa. For example, even amid growth’s strong run in recent years, value has held up well during bear markets. In the 2022 bear market, from January to mid-October, the iShares Russell 1000 Growth ETF fell 29%, while the iShares Russell 1000 Value ETF lost just 19%
The monthlong bear market in 2020, at the start of the Covid pandemic, was something of an anomaly, as work-from-home stocks like Zoom helped growth wallop value. The growth-oriented ETF lost 3.9% while its value counterpart fell 35%. But it still paid to diversify. “We love having both growth and value in a portfolio because one is typically outperforming the other, and that gives the portfolio stability over the long term,” says Roberts.
Ways to approach value investing
If value stocks are defined as those that are on sale, how do you know when a stock’s price is a bargain? Value investors study multiple statistical measures to answer that question.
Price-to-book ratio
Price-to-book ratios, which compare a company’s market value with its net assets — everything from property and equipment to patents — are a good place to start. A low ratio suggests that a stock may be undervalued relative to its intrinsic worth. For example, the price to book value of the iShares Russell 1000 ETF, representing a cross-section of large- and midcap stocks, is 9.6. For the iShares Russell 1000 Value ETF, it’s 3.8; for iShares Russell 1000 Growth ETF, it’s 14.7.
Price-to-earnings ratio
Price-to-earnings, or P/E, ratios are another tool of the trade. A lower-than-normal P/E ratio may signal an attractive opportunity. But what’s an attractive P/E ratio? It depends. A stock’s historical P/E, or that of its industry, can be a useful yardstick. Technology stocks’ long-term P/E ratio is around 20 to 25, for example, while utility stocks’ historical ratio is more like 10 to 15. Complicating matters, interest rates must be taken into account: When rates are low, bonds yield less, so investors can tolerate higher P/E ratios for stocks.
Earnings, the denominator of the P/E ratio, can be backward- or forward-looking — that is based on a company’s historical earnings or an estimate of its future earnings. Value investors typically use trailing-12-month earnings, while growth investors favor projected earnings. While growth investors are motivated by visions of future profits, value investors have a solid earnings history to guide their expectations.
Shiller price-to-earnings ratio
The Shiller P/E ratio, named for economist Robert Shiller, allows investors to dive a little deeper. Also known as the CAPE ratio, it averages companies’ earnings over a 10-year period to smooth out distortions caused by inflation and economic events like booms or recessions. This metric is generally used to analyze broad market segments rather than individual stocks, but it can point to sectors that are currently undervalued and are thus good hunting grounds.
No matter what version of the P/E ratio you use, beware of value traps — when an investment that appears to be attractively priced turns out to be fundamentally weak or deteriorating. “If a stock is cheap, it might be cheap for a reason,” says Amy Arnott, portfolio strategist at Morningstar. A classic example is Eastman Kodak. The one-time photography industry leader struggled to adapt to the digital-photo era. Its low valuation attracted investors, but the company ultimately failed, filing for bankruptcy in 2012.
How to invest in value stocks
There’s more than one way to build a portfolio of value stocks. The right way for you depends on the time and commitment you can realistically put toward this project — and don’t forget that you’ll also have to monitor your portfolio and sell when necessary.
Mutual funds and ETFs
The simplest approach is to open a brokerage account and buy a value-oriented mutual fund or exchange-traded fund, or ETF. Actively managed mutual funds buy and sell value stocks as attractive opportunities come along. Nuveen Multi Cap Value Fund (NQVAX), to name just one example, is up about 40% over the past five years and has a 1% dividend yield. Its managers pick stocks across the market-cap spectrum, with an emphasis on midcap companies. Value investors often target midcap companies because they frequently have established operations and are stable while still small enough to be overlooked by big institutional investors.
Less expensive and more tax efficient are value-oriented ETFs. Most are passive, holding a fixed roster of stocks. One of the most popular is the $26 billion iShares S&P 500 Value ETF (IVE), which has risen 6.8% annually in the past five years and sports a dividend yield of 1.8%. It’s a passive fund, owning a fixed roster of large companies that fit the value description, and it’s cheap, with a management fee of just 0.18%.
Factor ETFs
Vehicles known as factor ETFs let investors double down on value and other investment criteria. So-called value-factor ETFs — which use sophisticated computer models to screen for everything from low P/E ratios to price momentum to management quality — tend to include relatively fewer names. That means the possibility of greater returns but also greater risk than a broadly diversified value fund. iShares Edge MSCI U.S.A. Value Factor ETF (VLUE), with $6.9 billion of assets, rose 1.3% annually over the past five years.
Individual value stocks
A value mutual fund or ETF can provide diversification, spreading bets around and protecting you from being too badly hurt should one or two stocks tank. But it can also dilute the impact of standout performers. Picking your own stocks allows you to tailor your portfolio, with the potential for higher returns.
A time-tested way to learn how to pick value stocks is to read the classic investing texts: “Security Analysis,” by Benjamin Graham and David Dodd, and “The Intelligent Investor,” by Graham. These books have long been considered bibles of value investing. While Graham was a mentor to the most successful value investor ever, Warren Buffett.
A word of caution: Stock picking requires extensive research, constant monitoring and an abundance of patience. You may identify stocks that the market has overlooked — but “it can take a long time for other people to realize the value of those names and for that value to be unlocked,” says Roberts. Until they do, your stock’s price may languish.
Berkshire Hathaway
If you’re a fan of Warren Buffett, but don’t think you can emulate him, you can also simply invest alongside him. Class-B shares of Berkshire Hathaway — the holding company that owns part or all of companies handpicked by Buffett and his partner Charlie Munger — recently traded around $364. Berkshire Class-B shares have risen nearly 12% annually over the past five years, and are up about 1,400% since their debut in 1996. By the way, Morningstar’s estimate of the stock’s fair value is $370. “Based on that,” says Arnott, “it would be slightly undervalued.”
Just remember: Even though Berkshire Hathaway owns interests in numerous businesses, it’s still a single stock. A healthy, diversified investment portfolio typically includes several dozen.
Got a money question? Let Buy Side find the answer.Email[emailprotected].
Include your full name and location, and we may publish your response.
More about investing
- Best Growth Stocks
- Best Vanguard Funds
- Best Long Term Stocks
Meet the contributor
Steve Garmhausen
Steve Garmhausen is a contributor to Buy Side from WSJ.
