The art of value investing: How to identify undervalued assets

Kuwait: Value investing involves selecting stocks listed in the public markets trading at a price below their fair or intrinsic value. The concept of value investing was popularized by Benjamin Graham and the approach was adopted by many successful investors such as Warren Buffet. Stocks can become undervalued for several reasons, often related to market psychology, company-specific factors, or broader economic conditions.

Regardless of the reason for a stock becoming undervalued, it represents an opportunity for a value investor to capitalize on. Fund managers use a range of techniques and metrics to assess intrinsic value and screen for potentially undervalued stocks such as price relative to earnings, book value or cash flow where a lower ratio may indicate that a stock is undervalued. The fund manager should then also evaluate the quality of the company’s top and executive management, its business model, the outlook for the business, industry trends and the company’s standing relative to its competitors (peer analysis) before making an investment decision.

Value investing carries risk just like all other investments, one key to long term success is to invest with a margin of safety. The margin of safety refers to the difference between the intrinsic value of a stock and its market price. It acts as a buffer against errors in estimation or unforeseen events, offering a cushion for potential losses. When buying undervalued assets, it can take time before the market recognizes their true worth and therefore value investors typically have at least a 3–5-year horizon.

Stocks that appear to be undervalued but fail to realize their potential are referred to as value traps and should be avoided by conducting thorough research to understand the company’s prospects. An active manager with strong research capability can add significant value by helping investors avoid value traps and constructing robust, diversified portfolios of value stocks.

Growth stocks (stocks expected to grow at an above-average rate) typically perform better during periods of strong stock market performance and when corporate earnings are on the rise. However, during economic slowdowns, growth stocks tend to underperform value stocks. Value tends to outperform growth during periods of weak stock market performance and in the early stages of an economic recovery. Value stocks typically offer higher dividend yields, which is particularly relevant for investors with a focus on income generation.

In recent years, value has significantly underperformed growth, leading to growth stocks being valued at near all-time highs relative to value stocks. Due to the recent outperformance, investors in the US large cap market have overweighted their portfolios towards growth stocks, driven partly by the strong performance of the so-called “Magnificent Seven”. Long-term investors should be cautious of having a significant underweight exposure to value stocks, as relative valuations can vary significantly throughout an economic cycle.

In conclusion, value stocks are currently at historically low valuations compared to growth stocks, key indices are overweight growth due to recent outperformance of the growth style. A long-term horizon is key for an investor that wants to explore value opportunities and an active manager can add significant value by identifying attractive stocks and ensure a robust portfolio construction with sufficient diversification.