The value trade - are you in?

What are value trades and why are they so popular?

Value trading is a concept that can be traced back to the mid-20th century to two Columbia Business School professors: Benjamin Graham and David Dodd. Value trading is based on the simple premise that when you know the true value of something you can save money by buying it when it’s on sale. This common-sense investment strategy involves the selection of stocks that seem to be trading below their ‘intrinsic’ or book value.

Value traders must carry out thorough reviews of the stock market to identify stocks that bear the signs of being undervalued. Such underestimations are often due to heightened responses to positive or negative news within the market. This provides traders with the chance to buy a potentially valuable stock at a discounted rate. There are major benefits to buying and retaining such stocks over the long term.

But why are they such a hot investment topic right now and why should you consider adding them to your portfolio in 2021?

How has investor sentiment changed?

In recent weeks there have been numerous reports of a switch in investor sentiment from growth to value. Tradestation has focused on the marked contrast in directions taken by the iShares Value ETF (IWD) and iShares Value Growth ETF before the reported earnings of Apple (APPL), Microsoft (MSFT) and Amazon.com (AMZN). These earnings went up and rapidly dropped away in line with the expectations of international investors.

The recent fluctuations bear great similarity to those witnessed in late January, which were followed by a period of relative strength in value stocks. Given the recovery of the labour market as a result of economic reopening, this scenario is expected to repeat.

It comes as no surprise then that Vice Chairman and Head of Investment Group Charles K Bobrinskey at Ariel Investments has predicted the continued rise in the popularity of value stocks, given their affordability versus growth. He went on to say further that the rate of recovery from the pandemic is proving faster than most people were predicting at the turn of the year. Office rates are holding their value, theatres are reopening, the number of international travellers is growing and earnings are coming in particularly strong.

Why are value trades so attractive in the UK?

Brobonskey’s points apply equally to the rapidly recovering UK market. Confidence in value trading stemming largely from the apparent cheapness of such stocks against benchmarks such as dividend payouts and assets. Prices have decreased as a direct result of concerns over Brexit and the economic impact of Covid-19 with value stocks driven to rates below those witnessed at the height of the tech bubble in 2020.

The huge drop in the pricing of value stocks has been reported by respected publications such as the Financial Times, with comparisons drawn between the UK and global developed equity markets. However, it has been argued that the perceived value of such stocks is bound to rise significantly given the expected return of economic confidence over the coming months and years.

It is widely anticipated that the UK will remain a major player on the global economic scene, maintaining and forging new connections with international partners. This positivity is reflected in the OECD’s forecast of UK economic growth rates of 5.1% and 4.2% for 2021 and 2022 respectively.

Despite a marked increase since the start of 2021, the pricing of value stocks is still cheap and attractive when compared with historical records.

While global developed equities are expected to deliver an annual return of 4% over the next decade, UK value stocks are expected to give a 12% return. This means that investors could stand to double their money in six years.

What’s the best approach in terms of value investment?

Several characteristics have a bearing on the success of value investors. Prospective investors are reminded of the importance of staying independently minded and not making decisions based on the efficient-market hypothesis. 

Savvy investment choices will be made in consideration of verified financial data, rather than the trendiness of stocks. Intrinsic value will be the key factor, with purchasing decisions being based on sound principles and financials. Value investing is a long game and you may have to wait a number of years before your investments give healthy returns.

Investment expert Christopher H. Browne recommends considering these revenue-boosting business activities:

• Raising prices on products
• Increasing sales figures
• Decreasing expenses
• Selling off or closing down unprofitable divisions

Browne also points out the sense of reviewing the competition for some idea of future growth prospects. However, this highlights the issue of value stock investments being based on predictions rather than supporting data. As such, it might be worth following Warren Buffet’s advice of restricting investments to industries that you have experience with.

Confidence may be taken in the prospects of value stock when:

• There is evidence that stocks have been bought by established business stakeholders
• Published financial data shows that the company is performing relatively well.

What are the risks of value trading?

There are risks associated with value investing, just as with any other type of investing strategy. Reference must be made to updated financial information and accurate calculations for confidence in the purchase of value stocks. Time spent learning how to interpret financial statements is sure to prove worthwhile.

It’s also advisable to carry out thorough reviews of footnotes within the Form 10-K or Form 10-Q for a sound understanding of any single company’s financial standing. Red flags should be raised wheneever such footnotes are difficult to understand or feature unreasonable data.

Care should also be taken to avoid these mistakes:

• Failing to account for extraordinary item gains or losses
• Ignoring ratio analysis inconsistencies
• Not spreading the risk through investment in multiple stocks or stock indexes
• Making buying and selling decisions based on responses such as fear and excitement
• Overpaying for value stock (the price will ideally be two-thirds or less of the intrinsic value)

Time to make value investments?

Although there are good reasons for confidence in the prospects of value stocks, value investing should be considered a long-term strategy. You can expect to hold such stocks for several years, with the decision to sell likely to be made only in the event of a major purchase or retirement. 

However, the benefits of such a long-term commitment may well be significant as value stocks have just as much potential as growth stocks. You can reap major financial rewards when you identify and trade stocks for less than they are worth.