The prospect of higher US growth this year has sparked renewed interest in value stocks. Given that stronger economic growth is expected to lift more company earnings across the board, an increasing number of investors are turning to value stocks – stocks they believe that the market has undervalued.
Investors who use the value investing strategy believe that the market overreacts to both good news and bad, resulting in stock price movements that do not correspond with a company’s long-term fundamentals. This presents an opportunity to profit when the price is deflated.
When it comes to value investing, going against conventional wisdom may just be your best bet to increasing investment performance. Here are some common market scenarios and how going against the grain can help you make the best of the situation:
Market scenario #1: Unfamiliar stocks
Common logic: Many investors find comfort with the idea of familiarity and balk at putting their money on unfamiliar stocks. The general perception may be that such stocks are lousy or pose considerable risk, and give little assurance to potential investors.
Counter-intuition: Less interest from investors means less demand, which means that these stocks are more likely to be undervalued – presenting the much-coveted opportunity to “buy low, sell high.”
Market scenario #2: Low liquidity
Common logic: There’s generally less demand for unfamiliar or small cap stocks, so they have a lower trading liquidity. For investors, this means enough shares at the right price may be unavailable when want to buy, or at times, it may be difficult to sell shares quickly at favourable prices. When there are no buyers, you can’t sell your stocks, and you’ll be stuck with them until there is interest from other investors.
Counter Intuition: Demand and supply are transient, and certain events could trigger a spike in valuation. After all, that what goes up must come down and vice versa.
However, it is worth noting that low liquidity could also mean stability, as investors holding to a stock continue to see value in the long term and do not wish to trade or sell it.
Market scenario #3: Small companies
Common Logic: Company size is often seen as a main factor in determining the quality of a stock. So, stocks of smaller companies (or small cap stocks) are commonly seen as weak and risky, frequently fraudulent and lacking in quality.
Counter Intuition: Some small cap companies are debt-free and financially healthy, so the popular generalisation that small cap companies lack quality isn’t always true. Further, many successful large cap companies today started as small businesses, including Apple and Microsoft. Small caps give retail investors a chance to get in while these companies are budding.
Market scenario #4: Companies with problems
Common Logic: Why invest in companies with problems when you can invest in winning ones?
Counter Intuition: Firstly, problems drive stock prices lower. This could be triggered by specific events, such as a product recall. Once these issues are resolved, stock price might recover.
But don’t focus solely on low stock prices. Some stocks are cheap because their equity is compromised by the debt side of the equation. The important thing that investors need to look at are the fundamentals of a company, while taking debt into account.
Market scenario #5: Unproven business models
Common Logic: Small companies are unlikely to have an established or loyal customer base, and come with potential added risk for an unproven business model to fail. These factors make it hard for smaller companies to win investor confidence.
Counter Intuition: Small caps companies have the ability to grow in ways that are no longer possible for large companies. For instance, a large company with a market cap of US$1 billion would not have the same potential to double in size as a company with a US$100 million market cap. Further, small companies are able to pivot faster and switch to a winning strategy if their current one prove to be ineffective. So, for investors who are seeking high-growth companies, small caps are the place to look.
Value is a timeless investing style for those with the patience and foresight. However, as with most investment strategies, it always pays to diversify your portfolio to manage risk. In short, never put all your eggs into the same basket.
Importantly, you also need to verify information you come across, because data is never 100% accurate. Unfortunately, fraudulent reporting can occur.
Finally, while no investor ever goes into the market thinking they would lose, if it happens, don’t let your ego get in the way of making the right decision. Sometimes, the best course of action may just be to cut your losses and move on to the next deal.