Topic: Value Stocks

Long-term value investing tips—and traps to avoid

long term value investing

Long-term value investing is a key part of building a balanced and diversified portfolio

The core of the long-term value investing approach is identifying well-financed companies that are established in their businesses and have a history of earnings and dividends. They are likely to survive any economic setback that comes along, and thrive anew when prosperity returns, as it inevitably does.

Read on to discover more tips for value investing, and investing traps to avoid.

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Picking the top stocks for long-term value investing

When you look for stocks that are undervalued, it’s best to focus on shares of quality companies that have a consistent history of sales and earnings, as well as a strong hold on a growing clientele.

High-quality value stocks like these are difficult to find, even when the markets are down. But when you know what stocks to look for, you can discover them. Here are three of the financial ratios we use to spot them:

  • Price-earnings ratios
  • Price-to-sales ratios
  • Price-cash flow ratios

Avoid value traps for long-term value investing

Some of the measures that lead you into value traps are statistical. They include unusually high dividend yields, unusually low per-share price-to-earnings or P/E ratios, or a low ratio of stock price to book value or other measures of per share value.

Any of these measures can make it seem like a stock is a bargain. But in fact, any of them can simply be due to a low stock price that is the result of selling by well-informed investors who recognize a dismal long-term future.

Another way to fall into a value trap is to put too much faith in the value of a brand name. A strong brand can sell a lot of a strong product, or keep an over-the-hill product going long after competitors have faded. But even the strongest brand name can only do so much.

Compound interest is an impactful part of long-term value investing

Compound interest—earning interest on interest—can have an enormous ballooning effect on the value of an investment over the long term, and lift the overall returns on your portfolio.

This applies to equity investments like stocks, as well as to fixed-return, interest-paying investments like bonds. When you earn a return on past returns (including dividends), the value of your investment can multiply. Instead of rising at a steady rate, the number of dollars in your portfolio will grow at an accelerating rate.

Long-term value investing versus growth investing

Academic studies suggest that on average, value investing produces better results than growth investing. But these studies mostly look back on what would have happened in a particular historical period, if you followed a particular set of rules. Most distinguish between growth and income investing by looking at average p/e’s (per-share price-to-per-share earnings ratios). They assume high p/e’s are a marker for growth stocks and low p/e’s for value stocks. As any serious value or growth investor can tell you, it’s more complicated than that.

If you balance and diversify your portfolio as we recommend, it should include both growth and value selections. In both areas, however, you should avoid extremes.

If a stock seems like an exceptional bargain in relation to earnings or asset values, it may suffer from hidden risks. The stock can plunge when those problems begin to take their toll.

On the other hand, if a growth stock trades at such a high price that it needs exceptional results to move ahead, then it suffers from obvious rather than hidden risk: a single quarter of bad earnings can spark a collapse in its value.

Some investors see interest rates as the single most important factor for the market

The problem with the “most-important-factor” approach is that the factor you single out may be less important than you think. Moreover, even if it is the crucial factor, it may be just as hard to analyze as the market outlook is.

It pays to look at it from a long-term point of view.

Interest rates generally hit a peak around 1980, then settled into the long-term falling trend. Starting from fall 2014, the yield on the 30-year U.S. Treasury Bond has gone sideways, staying in a range between 2.2% and 3.2%.

When an interest-rate trend lasts for decades, it may need a few years to reverse course. After that, it may need a few more years to build any lasting momentum.

In the meantime, stock and bond prices will both stay volatile. But stock prices are likely to move upward. High-quality stocks will continue to pay dividends, and the best of the bunch will raise their dividends.

What do you think is the single most important factor for the market?


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