Value investing claims that the stock market sometimes undervalues a stock's true worth, as revealed by financial information.
The theory claims that the market is slow to react, but in time it will eventually assign a value that accurately prices a security.
A value investor (see Value Averaging) looks for a stock that is trading at or below what it really is worth.
Why it's important to know about this?
There are two distinct ways to determine if a stock is trading too cheaply:
1. One way is to compare the stock with other stocks.
Usually the markets run in cycles. If everyone is currently buying technology stocks, perhaps they are selling bank stocks.
Bank stocks might be sold off more than what they should have, which could result in giving the savvy investor an opportunity to find a good value in a stock (within a sector) that is currently unloved.
Look at the ratios: If a technology stock and a bank stock both grow earnings 15% a year, but the technology stock is trading at a P/E ratio of 30 and the bank stock's P/E is 20, it looks as if the bank stock is cheaper.
2. The other way an investor might spot value is to know something about the company that he doesn't believe is factored into the price.
AAA company coming out with a new "Miracle Product."
ABB company owns real estate worth several billions that is not reflected properly on the balance sheet.
XYZ industry being deregulated promising more mergers and acquisitions.
The advantage to this strategy is usually less volatility and less downside risk if the markets start to fall. The biggest criticism of value investing is that it often times doesn't provide instant gratification.
Many investors want to see their stock double within weeks of buying it. On the other hand ...
Value investors often have to wait for a lot longer than that!