Some investors search for stocks they believe the rest of the market is undervaluing, and that will at some point catch up and outperform in the future. This is an investment strategy summarized by the oft-repeated phrase, “buy low and sell high.”
Two of the best-known value investors are Warren Buffett and his mentor, Benjamin Graham, who is considered the father of value investing. Both used value stocks to create huge investment portfolios.
Benjamin Graham may or may not have come up with the idea of value investing, but he certainly fine-tuned it. He taught the process of fundamental analysis (later coining the term “value investing”) as an adjunct professor at Columbia University in the 1920s and used it to amass wealth in the stock market.
Both Graham and Buffett found undervalued stocks and purchased them as part of an overall long-term investment strategy. To provide a safety buffer, Graham was said to have only purchased shares if the stock price was two-thirds (or less) of its intrinsic value.
Finding and choosing the right securities, however, can be an enormous challenge. Many other investors also are looking for stocks they can buy on the cheap, so the process of discovering stocks that really are trading at a discount can thwart even the most sophisticated financial analysts.
Value stocks definiyion
Value stocks are investments that are believed to be underpriced compared to their intrinsic value in the stock market. “A value stock is a company or a share that is trading basically below the actual value of the business,” says Titan strategist Myles Udland.
Investors seek out value stocks in an effort to capitalize on that underestimated value, ideally reaping the benefits when those stocks correct to their true value.
While not always the case, value investors tend to look for stocks that are relatively unknown, or underexposed, with potential value. They may also choose to buy shares when the market experiences a shift or external shock—such as during the Great Recession, when many investors desperately sold their holdings, or when the market dropped in March 2020 at the beginning of the COVID-19 pandemic.
Timing the purchase (and later, the sale) of a value stock may perhaps be the most important aspect of this investment strategy. Buying while the stock is still lesser known or undervalued allows an investor a chance to truly maximize on any eventual growth of the security.
Choosing a value stock
The “value” of a value stock comes from buying it at a lower cost than the total underlying value of a company’s assets. It’s a bit like purchasing a $15,000 car for $10,000—or snagging a $100 gift card for just $75. But value investing only works if the stock is priced at a discount to its intrinsic value.
When choosing value stocks, investors generally analyze the stock and consider a variety of factors, including:
- Overall market trends
- Past financial performance
- Expected market growth and demand
- Industry competition and expected development
Potential upsides to investing in value stocks
Investing in any type of stock comes with risk. There is no proven way to predict what the market as a whole, or any individual security, will do over time, and there’s no guarantee of growth or return on a stock. For this reason, value investing can be a bit of an art. Choosing the right investments usually means analyzing a company’s financial statements and estimating its potential for growth. If everything goes right, value stocks can offer these upsides:
- Potential gains. The well-timed purchase of a true value stock can be lucrative for an investor, especially if they find the overlooked securities at an opportune time.
- Less risk. Because value stocks are purchased at a discount (and typically as a long-term investment), they can pose less risk to the investor.
- Possible dividends. Many value stocks pay dividends to investors on a regular basis, providing a source of passive cash flow.
Potential downsides to value investing
Value stocks can have drawbacks. Choosing a worthwhile value stock can be a matter of timing, accurate prediction and a lot of hard work that requires skills not all investors have.
- Requires patience. In many cases, value stocks usually are bought as longer-term investments without any expectation that they will be an overnight success. Investors need to be prepared for a long haul if they are seeking value growth.
- Accurate valuation is hard. Hindsight is 20/20, but investors don’t have that luxury when choosing value stocks. Determining which investments are truly undervalued—and what their accurate value should be—is one of the biggest challenges that advisors and investors will face. Says Titan strategist Udland, “The job of a value investor is to assume that I'm right and that the market is wrong.” This is a tall order for most investors.
Value stocks vs. growth stocks
Value investing and growth investing are two different styles of portfolio management. Though they both rely on potential future performance, there are a few important differences to note between growth and value stocks.
- Value stocks are thought to be undervalued. This means they’re trading at a share price that’s below their intrinsic value. The belief is that when this stock eventually corrects to its true value (or higher), the investor will recognize those gains in their portfolio.
- Growth stocks aren’t believed to be undervalued. Instead, growth stocks are securities that hold the potential for overperformance, or future growth that exceeds that of the overall market.
- Neither is guaranteed. Both types of stocks hinge on the investor’s belief that the stock (and the market) will perform as expected.
Although they do differ from one another, it doesn’t necessarily have to be an either/or decision for an investor.
The bottom line
Purchasing value stocks—or shares of a company believed to be underpriced compared to its intrinsic value—is a key aspect of value investing. This investment strategy seeks to identify and capitalize on the hidden gems of the stock market, providing investors with potential for growth if and when the shares correct to reflect the underlying value of a company’s assets.
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