What Makes Value Investors Rejoice?

Josh McClellan, AAMS®, RIA Compliance Consultant
January 23, 2019

When markets swoon, a certain class of investors see buying opportunities around every corner. Unlike many investors, these market participants – known as value investors – look forward to falling share prices as a chance to buy quality, name-brand companies at a discount.

What comprises a discount in a stock’s price? Many different investment metrics exist to help identify when a company’s stock is on “sale” and comprises a value, or even better, a deep value.

A common tool many value investors use is the price-to-book (P/B) ratio. P/B ratios are calculated by dividing the market price per share by the book value per share.  The lower the ratio for one company in comparison to other companies in the same industry, generally, the greater level of value.

While this tool can be somewhat subjective in its approach, calculating the P/B ratio helps assess if the underlying assets of a company are being fairly valued by the market or if they can be purchased below their intrinsic value.

A key element of this style comes from the margin of safety factor inherent in value stocks. Take a hypothetical blue-chip, well-known company for example. This well-established company has been shown to generate growth in long-term portfolios. While this hypothetical stock has historically traded around $80 a share, it has recently fallen to $45 a share due to a broad market selloff or an overly emphatic concern about underlying industry weakness.

In this example scenario, a value investor who purchases the company at a reduced price understands that not only are they buying ownership in a company for less than its worth, but that in time, the company’s continued earnings should help return its share price to its fair value range. In general, the low price, relative to historical norms, can help mitigate further downside risk and lead to future gains as share prices have a long-term tendency to revert to the mean.

Another popular metric that value investors hold near and dear is the ability to collect dividends. Many publicly-traded corporations exist who have consistently paid dividends for decades, as well as increased their dividends over time. When the company’s share prices decline, it offers investors a chance to buy shares at favorable yields. Of course, in order to be able to pay a dividend, a company must have the underlying earnings to support it. Otherwise, the company can be considered a value trap, and the likelihood of future dividend cuts is very high. The payout ratio, which is equal to the dividend per share divided by earnings per share, is an important metric that helps identify if companies have the cash flow to be able to support the dividend. The lower the payout ratio, the more cushion a company has to not only support future dividends but also grow dividends.

It should be noted that true value investors look for quality companies that they believe offer a valuable product or service but whose shares are only temporarily out of favor. Often these companies have sound balance sheets and offer an economic moat or a high barrier of entry to outside competition.

It is these critical factors that ultimately determine the long-term health and share price of any company. The success of this style of investing depends not only on identifying great value investments, but on having the patience to allow them to succeed. As Warren Buffet has said, “Price is what you pay. Value is what you get.”  

 

The views and opinions expressed herein may not be suitable for all investors. This commentary is for informational purposes only and should not be construed as investment advice.

Past performance is no guarantee of future results.

Securities offered through 1st Global Capital Corp. Member FINRA, SIPC.

Investment Advisory Services offered through 1st Global Advisors, Inc.

 

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