Value investing: What it is and how it works

Value investing vs. growth investing

Value investing focuses on finding stocks that appear to trade below an investor’s estimate of intrinsic value. In contrast, growth investing targets companies that some investors expect to grow faster than the broader market.

Value investors often focus on valuation relative to fundamentals, while growth investors often focus on expected revenue, earnings or market-share growth. Growth companies are often associated with sectors such as technology, healthcare or consumer discretionary, although growth expectations and earnings outcomes vary widely.

Growth stocks often trade at higher valuation multiples because investors may be pricing in expected future growth.

Risk and reward

Value stocks may offer a margin of safety when they trade below an investor’s estimate of intrinsic value, but that estimate may be wrong, and value stocks can still be volatile or underperform.

On the other hand, growth stocks often come with higher risk, as their success depends on future performance rather than current fundamentals. Investors in growth companies are relying on continued expansion, which may not happen as expected.

Which strategy is better?

Value investing has sometimes performed better during certain periods of economic recovery or market corrections (when investors often seek stability and lower-risk investments), but results depend on the period, index, valuation method and definition of value. Growth stocks have sometimes outperformed during bullish markets when expectations for future earnings rise, but this pattern is not consistent.

Choosing between value and growth depends on market conditions, investment objectives, valuation, time horizon and risk tolerance.

Value investing strategies

Value investors use a variety of approaches to assess whether stocks appear undervalued. Here are some of the most notable ones:

Contrarian investing

Contrarian investors take positions that go against the prevailing market sentiment. They seek out companies they believe are undervalued due to negative market sentiment or temporary setbacks. By focusing on long-term fundamentals, contrarian investors expect the market to eventually reassess the company, although this may not happen.

Deep value investing

Deep value investors look for stocks that appear to trade at large discounts to their estimated intrinsic value. These stocks are typically distressed or out of favour due to significant market pessimism or operational struggles.

This strategy carries higher risks because distressed or out-of-favour companies may continue to decline, even if they appear cheap.

Dividend value investing

This strategy focuses on companies that appear undervalued and have a history of paying dividends. Investors using this approach aim to generate regular income from dividends while waiting for the stock's market price to appreciate, but dividends can also be reduced or suspended.

This method may appeal to income-focused investors, although both capital appreciation and dividend income are uncertain.

GARP (Growth at a reasonable price)

This strategy combines principles of both value and growth investing. Investors following GARP look for companies that exhibit consistent earnings growth but are also trading at a reasonable valuation.

Essentially, they seek companies that combine growth characteristics with valuations they consider reasonable. GARP investors use metrics like the PEG ratio (Price/Earnings to Growth) to assess whether a company’s valuation appears reasonable relative to expected earnings growth.

Low Price-to-Earnings (P/E) strategy

This is a classic value strategy that targets stocks with low P/E ratios. The idea is that a low P/E ratio may indicate that the market is assigning a lower valuation to the company’s earnings. Investors using this strategy believe the stock price may rise if the market reassesses the company’s earnings power, but this may not happen.

Net-net investing (liquidation value)

Popularised by Benjamin Graham, this strategy focuses on finding companies trading for less than the value of their net assets (total assets minus total liabilities).

Investors target companies they believe are priced at or below their liquidation value, although liquidation value can be uncertain and difficult to realise in practice. This strategy is rare and high-risk because recoveries may not materialise and losses can be significant.

Behavioural biases and value investing

Market psychology can influence prices and may create valuation differences that value investors try to assess. Emotional reactions and cognitive biases can contribute to price movements that value investors may interpret as mispricing. While sentiment can affect market behaviour, value investors usually focus on the long-term fundamentals.

How market psychology can affect valuations

When negative news appears or economic conditions worsen, some investors may sell quickly, contributing to price declines. In these moments, some stocks may appear undervalued relative to their fundamentals. Value investors may view these price declines as opportunities, but further analysis is needed to assess whether the discount is justified.

Conversely, during periods of strong optimism, stock prices may rise above some investors’ valuation estimates. Value investors typically avoid stocks they consider overvalued, on the view that prices may adjust over time.

Common market biases

Here are the most common market biases:

Overconfidence bias

Some investors may overestimate their ability predict market movements. This overconfidence may contribute to risky behaviour, especially in bull markets, where stocks may become overpriced. However, value investors typically try to focus on fundamentals rather than short-term sentiment.

Loss aversion

Loss aversion may lead some investors to sell during downturns, even when a company’s fundamentals have not changed materially. Value investors may buy during these periods of negative sentiment, although doing so can still lead to losses if the investment thesis is wrong.

Herd mentality

Herd behaviour can contribute to rapid price increases, especially when investor interest concentrates around a company or theme. Value investors may buy stocks that others have overlooked or sold, although an eventual market correction is never guaranteed.

Is value investing dead?

In recent years, value investing has faced scrutiny, especially as growth stocks in sectors like technology have dominated the market. This has led some people to question whether value investing is still relevant in today's economy.

While growth stocks have outperformed value stocks in certain periods, value stocks have performed better in others. Results vary by timeframe, market, index and definition of value.

The case for value investing's struggles

In recent years, some technology and growth-oriented companies have traded at valuations based more on expected future growth than current earnings. That’s why investor demand for growth stocks has at times pushed valuations higher, contributing to periods when value strategies have lagged.

Easy access to capital, rapid innovation, and interest-rate conditions have at times skewed market sentiment toward high-growth companies.

However, value-stock underperformance has often reversed, although the timing and extent of any reversal are uncertain. Value stocks have sometimes performed better during certain market corrections or recoveries, but this pattern is not consistent across all periods or markets.

The principle of buying assets below an investor’s estimate of value remains central to value investing, but the market may not always correct as expected and apparently cheap stocks can remain cheap or decline further.

Conclusion: How value investing can fit into an investment approach

Value investing remains a way for investors to assess whether a stock’s market price is below a reasonable estimate of its underlying value. The approach focuses on fundamentals, valuation and patience, but it depends heavily on the quality of the analysis and the assumptions used.

Growth and value strategies can perform differently across market cycles, and neither approach works in all conditions. Overall, value investing may help investors follow a more disciplined process, but a margin of safety is only an estimate and does not remove the risk of losses.