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Warren Buffett is one of the most successful investors in history.
He once wrote of his strategy: “Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”
Buffett’s bargain-hunting approach to the stock market is commonly known as value investing — a strategy that investors have been studying and practicing for nearly a century.
Despite Buffett’s success, value investing has had a mixed track record in recent decades. Historical data suggests that value stocks lagged behind other kinds of stocks from the 1990s to the late 2010s.
But some experts believe that’s changing in today’s rising interest rate environment.
What is value investing?
In simple terms, value investing means buying stocks that you think are worth more than their current market price.
In other words, value stocks are companies whose share prices are lower than they “should” be, judging by fundamental financial metrics such as earnings per share.
Some value investing strategies involve buying stocks that have fallen out of favor with investors, in the hope that their strong fundamentals will propel a rebound in their share prices.
Value stocks are often contrasted with growth stocks, whose appeal is based on rapid increases in earnings or revenue.
“Generally, value stocks have better fundamentals than growth stocks,” says Michael Chomiak, an investment manager and financial advisor at Access Wealth in East Hanover, New Jersey.
“They’re usually more mature businesses that pay steady dividends, and that have free cash flow,” he says.
Given its focus on consistent fundamentals and comeback stories, value investing tends to be more long-term-oriented than growth investing. Buffett once wrote that “our favorite holding period is ‘forever.’”
Chomiak agrees. He says value stocks “are more of a consistent grower over time than growth stocks.”
How do you find value stocks?
Value investors use a variety of metrics to identify bargain-price stocks. Chomiak says that the price-to-earnings ratio, or PE ratio, is one of the most important.
A stock’s PE ratio is its share price divided by its earnings per share over the last 12 months. “The higher the number, the more expensive the [stock] would be,” he says.
Chomiak says that value investors typically look for stocks with PE ratios below 14, which is a bit less than the S&P 500 index’s historical average PE ratio of 15.98.
He says that positive free cash flow, another measure of profitability, is another good thing to look for when identifying value companies.
“Positive cash flows give them the opportunity to reinvest in the business, to do buybacks, and to increase dividends,” Chomiak says.
Other signals that value investors look for include low debt-to-equity ratios and high return-on-equity ratios. All of these metrics can be found on an online broker’s stock screener, or on a website like Yahoo Finance.
Do rising interest rates benefit value investors?
Historical data suggests that value investing has been especially profitable when interest rates are high — and they’re currently on the rise. The Federal Reserve has increased the federal funds rate six times so far this year.
“This is a time for value stocks. With interest rates rising, the cost of capital becomes much more expensive,” Chomiak says. “Typically, growth companies are borrowing at a much higher level than value companies,” Chomiak says.
“The value trade has certainly picked up a lot of steam, and for good reason. It’s a safer place to be in volatile times,” he says.
On the other hand, Dartmouth College finance professor Kenneth French said in an email interview that he’s not sure if interest rates affect value investing returns.
In a 2020 paper, French and University of Chicago professor Eugene Fama compared the returns of value stocks with those of the market as a whole between July 1963 and June 2019.
They found that value stocks had an advantage over the market in the first half of the study period — 1963 to 1991. But this advantage disappeared in the second half — 1991 to 2019.
On average, the Federal Reserve’s benchmark interest rate was more than twice as high in the 1963-1991 period as in the 1991-2019 period. The federal funds rate was also in a long-term upward trend in the first period, while it was in a long-term downward trend in the second.
However, French said that his research doesn’t prove a relationship between these things.
“We can’t tell whether [changes in value investing returns] just happened by chance, or there was a fundamental change in the economic environment,” he said.
Should you start searching for value stocks?
Whether or not you should invest in value stocks depends on your investing goals and how much time you have. Value investors are bargain hunters who use metrics like PE ratio and free cash flow to identify cheap stocks with long-term potential.
This kind of investing often involves a lot of time-consuming research. It also usually means buying individual stocks, which can be pricey.
Some advisors think rising interest rates could give value stocks a boost, and the relative performance of value stocks appears to be correlated with interest rates. But researchers aren’t sure there’s a causal relationship between the two.
Whether or not we’re headed into a value investing renaissance, beginner investors should note that it can take a lot of work — and money — to do the strategy right.
Index funds may offer steadier returns with less maintenance and a lower upfront cost.