We have been asked many times, “What is value investing and how can I profit from it?” The Successful Investor approach involves focusing on stocks that provide good prospects, but can be bought at a low price relative to other stocks on the market
What is value investing? Value stocks are typically stocks trading lower than their financial fundamentals suggest. They are perceived as undervalued and have the potential to rise. One of the best ways to boost your portfolio returns is to buy high-quality “value stocks” (or stocks that are reasonably priced, if not cheap, in relation to their sales, earnings or assets), then hold on to them as investors recognize their value and push up the price of their shares.
You need to develop an eye for value to succeed as an investor. And value investing should be one of the first approaches you look to.
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Canadian Value Stocks:
How to Spot Undervalued Stocks
PLUS! Our Top 4 Value Stocks
What is value investing? A way to diversify and invest in worthy companies
One of the most common investment platitudes you’ll hear is that investors should “have a plan (or system) and stick to it.”
This is good advice if your alternative is to invest without any sort of plan. However, unlike the time-tested value investing approach, many of today’s investment plans are not worth sticking with.
The best investment plans, or systems, use a variation of our Successful Investor approach and its strategy for value investing. That is, they revolve around choosing high-quality investments and diversifying your holdings. Our three-pronged value investing program takes that general description a little further. We advise you to invest mainly in well-established companies; focus on companies that are outside the broker/media limelight; and spread your money out across most if now all of the five main economic sectors (Manufacturing & Industry; Resources; Consumer; Finance; and Utilities).
There are numerous reasons why a top value stock might be underappreciated and inexpensive. The company might have experienced a period of stagnant growth (or even depreciating growth), which is why they fall into the category of “value stock.” Their business could have experienced temporarily lower sales because of bad publicity, legal issues, or simply lagging behind competitors.
A value stock could go through a turning point where most investors ignore it, but savvy investors see that there is also a great potential for it to bounce back and make a bigger impact in the market.
What is value investing? A way to find high-quality stocks.
When we look for value stocks to buy, we usually start by looking at these ratios:
Low price-to-earnings and price-to-sales ratios—can be signs of a cheap or undervalued investment.
Low price-to-book-value ratio—another sign that the stock is cheap in relation to other stocks on the market.
High dividend yield—the stock’s annual dividend divided by the share price. A high dividend yield could indicate a cheap stock that is set to rise.
What is value investing? A strategy that is proven to produce better results than growth investing—but don’t overlook growth stocks
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 using our Successful Investor philosophy, 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.
6 Successful Investor factors for a successful value investing strategy:
5 to 10 year history of profit. Companies that make money regularly are safer than chronic or even occasional money losers.
Industry prominence if not dominance. Major companies can influence legislation, industry trends and other business factors to suit themselves. Minor firms, on the other hand, don’t have that power.
5 to 10 years of dividends. Companies can fake earnings, but dividends are cash outlays. If you only buy dividend-paying value stock picks, you’ll avoid most frauds.
Geographical diversification. Canada-wide is good, multinational better. There’s extra risk in firms confined to one geographical area.
Manageable debt. When bad times hit, debt-heavy companies go broke first.
Freedom to serve (all) shareholders. High-quality value stock picks must be free of excess regulation, free of dependence on a single customer, and free from self-dealing insiders or parent companies.
Value investing may require too much patience for some investors. How long are you willing to hold a stock if it doesn’t make many gains?
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