A beginner’s guide to ‘value’ investing – everything you need to know

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So-called "value" stocks have soared recently and are expected to continue to rise, but experts say there are some key factors to consider before investing. 

First, what are value stocks and what does value investing mean? 

Teodor Dilov, fund analyst at U.K. investment platform Interactive Investor, said that value investing is, "all about investing in stocks that have been underappreciated by the market in the belief that their intrinsic value will shine through and translate to impressive returns in the long-term." 

There are a number of reasons why a stock could be considered undervalued. It could be that the sector a company belongs to is suffering from the effect of an economic downturn, for example, or that it operates in an industry that is considered to be outdated. 

Because of this, many value stocks often belong to what are known as "cyclical" industries, meaning their performance is linked to the strength of the economy.  

Cyclical industries explained

In the case of the coronavirus, the shutdown of many aspects of public life in an attempt to curb the pandemic hurt the stock markets of those countries worst affected, such as those in Europe. It also hit the share prices of certain industries directly affected by the restrictions, such as tourism and hospitality.

However, recent announcements about effective Covid-19 vaccines have signaled that economies could re-open fully, and businesses may soon go back to operating as normal. This has caused many of those stock markets and industries hammered by the crisis to rebound — and value stocks linked to these sectors have also benefitted.

The MSCI World Value index has risen more than 10% since the first announcement of an effective vaccine by Pfizer and BioNTech in early November, according to Refintiv data. It's outperformed the MSCI World Growth index, which has risen by around 2.5% and tracks so-called "growth stocks." 

Growth stocks, judged by investors to have strong future earnings potential, are often pitted against value stocks. During the pandemic-induced market downturn, growth stocks like the U.S. tech giants staged a massive rally but have since come off highs. 

Now attention is turning to value investing, and some analysts think these stocks will go even higher next year. 

But given that this style of investing means betting on out-of-favor companies, it requires investors to be "brave and patient," Russ Mould, investment director at U.K. stockbroker AJ Bell, told CNBC via email. 

He referred to a quote from legendary financial writer, Jim Grant: "Successful investing is about having people agree with you … later." 

So how do you know that you're investing in markets or stocks now that will grow your money later on? 

Ways to spot a value stock

There are many ways investors can assess whether a stock is undervalued. 

One way is to look at the stock's "price-earnings ratio," which is its share price divided by its earnings per share. The EPS is worked out by dividing the company's net profit (income minus expenses) by the number of shares it has outstanding. This can help investors tell whether or not a company is expensive in comparison to its peers in the same sector, for example. 

Adrian Lowcock, head of personal investing at U.K. investment platform Willis Owen, told CNBC on a phone call that this is a, "very quick way, and easy way, to work out whether a company's value is below or above that of the market, as an average." 

The "price-book ratio" is another tool investors use. It compares how a company is valued by the market to how it is valued based on its accounts. It is calculated by dividing a company's share price by its "book value" — the value of all of its assets minus any liabilities — per share. 

Lowcock referred to advice by Benjamin Graham, who was mentor to Warren Buffet and is considered the "father of value investing." When it comes to price-book ratios, one of Graham's 10 rules for selecting a stock is that its market value is below two-thirds of the book value of the business. 

Dividend yield, which is income paid out by a company as a percentage of its share price, can be another indicator of value. It is calculated by dividing the company's annual dividend by the current share price. The dividend yield therefore moves in the opposite direction to a company's shares, so a lower stock price would send the yield up and vice versa. 

While a high yield can mean a higher income, it may also indicate that further investigation into a stock is needed before investing, according to Lowcock. He said it can indicate that the yield is unsustainable, depending on the reason behind a share price fall. It could just be that shares have been dragged down by a wider market fall, "or it could be a sign of something more serious." 

Given that dividend yield isn't as straightforward to interpret, Lowcock said understanding it as an indicator of value is probably less relevant for a beginner investor. 

Value trap

Gauging whether a stock is undervalued is one thing, but investors also need to look for signs of a catalyst that could potentially turn around a company's fortunes in the future and send its share price higher.

"Without something happening that changes market perception of the stock, it could stay cheap or simply get cheaper," said AJ Bell's Mould.

A change of company strategy or new management are a couple of examples he highlighted. 

"Looking for potential triggers also helps you spot whether a stock is value trap — a cheap stock that deserved to be cheap and one that could therefore see its shares and market cap keep falling," he added.

Even armed with the basics, however, Interactive Investor's Dilov said value investing "can be quite confusing," so he recommended investing in this style via funds, which are managed by professional stock pickers. 

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