Growth stocks — equities that are expected to grow revenues faster than their average peers —have largely dominated markets over the past decade. But recent stock market volatility and fears of a recession have some investors turning from these generally riskier equities to value stocks. Should you? Here’s what you need to know.
Fundamentally sound, but undervalued
The goal of value investing is to identify companies whose stock prices don’t currently reflect what the investor considers their value. These companies are fundamentally sound but are undervalued by the market. They may trade at a relatively low price for many reasons. But usually they’re “cheap” because investors have reacted negatively to bad news, such as poor quarterly earnings or legal problems, or because the general market has declined and punished stocks across the board. Value investors hope that attitudes about these stocks will improve over time.
Investors use a variety of metrics to identify underperforming stocks. These include price-to-earnings, price-to-sales and price-to-book ratios. A low ratio relative to comparable stocks in the same industry may indicate that a stock is undervalued. It’s important to understand, however, that a low price isn’t necessarily a bargain price. Sometimes a company’s stock price declines because investors have correctly discerned real problems. And even from a low starting point, it’s certainly possible for stocks to fall in value further.
Prudence and patience required
Value investors look for stocks they believe offer strong future growth and earnings potential that has been overlooked by the market. Successful investors typically research companies thoroughly to evaluate their management, niche, competitive environment, cash flow, growth and dividend history.
Patience and a long-term perspective are critical. There’s a common misconception that buying bargain-priced stocks leads to immediate returns. In fact, it can take years before a value stock becomes what its investors consider fully valued. The performance of value stocks tends to be cyclical, alternately outperforming and underperforming other investments.
Cheap stocks can get cheaper
It’s important to note that some value stocks never realize investors’ expectations that their prices will rise. In fact, it’s possible to lose money investing in any type of security, including “cheap” value stocks. To reduce risk, assemble a portfolio of different types of investments — for example, value and growth stocks, bonds of varying maturity dates, and both domestic and foreign securities. Your financial advisor can help you build a diversified portfolio based on your goals and risk tolerance.
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