Market Overview

Value Stock Investments: Building A Durable Portfolio

Share:
Value Stock Investments: Building A Durable Portfolio

Weathering the financial markets through a storm of volatility can seem difficult and unsettling. But if you’re able to build and maintain a portfolio whose building blocks are durable and fundamentally sound, then you may find yourself weathering the storm better than your peers.

This is one of the core principles of so-called “value investing,” and a chief differentiator between value versus growth stocks. A stock that’s priced for high growth might produce higher returns over time, but might also be susceptible to higher volatility, which can drag down the “durability” of a portfolio.

Here are a few things to keep in mind if you’re considering applying value investing principles to pursue a durable portfolio. But remember: there’s a difference between “value” and “cheap.” As we’ll see below, sometimes a stock looks cheap, but because of deteriorating fundamentals or a weak outlook, is actually priced appropriately from a value standpoint.

In Pursuit of Durability

When extreme volatility hits the market, particularly during periods of secular decline, nearly all stocks are impacted—some more than others. Stocks get tossed up and down, and in the case of a major cyclical downturn, a great majority of stocks see their prices decline. In such an environment, growth stocks can get hit particularly hard.

So, in this context, what does it mean to have a durable portfolio? Durability refers to a portfolio’s capacity to avoid the largest drawdowns in price. It’s about reducing portfolio volatility despite greater conditions of volatility across the broader market.

How might you accomplish this? By holding fundamentally sound stocks that are not greatly overpriced by some of the metrics described below. In short, by holding “value stocks,” you might be able to reduce the level of drawdowns in your portfolio, achieving a relative degree of durability, as the most overpriced stocks may draw down at a greater rate than fairly priced or underpriced stocks.

Value Stocks and Value Investing

What is a value stock? It’s typically defined as one priced below its intrinsic value. In other words, it’s worth more, according to fundamental criteria such as expected future earnings, balance sheet health, and cash flow, but the shares just happen to be underpriced. 

Understanding the difference between a stock’s “price value” and “intrinsic value,” and buying what is underpriced yet fundamentally sound, is at the heart of a value investing approach. The theory behind this approach is that intrinsic value is like a tether: what is overpriced should eventually fall to its intrinsic value, and what is underpriced should eventually rise to its intrinsic value levels.

When we refer to value investing, what we mean is that we’re investing with an understanding of where a company’s stock is priced versus its intrinsic value. In the short run, investor overreaction to headlines, announcements, and trends can sometimes move stock prices away from a company’s intrinsic value. Overpriced stocks persistently trade above a company’s intrinsic value, while underpriced stocks trade below intrinsic value. Over the long term, investors tend to find that stocks converge with a company’s intrinsic value, meaning that overpriced stocks trend lower and underpriced stocks trend higher.

But here’s an important question: how might you know whether a stock is priced appropriately according to its intrinsic value? Here are a few simple metrics that can help identify which stocks might be sitting in the bargain bin.

 

Price-to-earnings or P/E ratio: This ratio indicates how much an investor is willing to pay for every $1 of a company’s earnings. A high P/E may suggest that investors are expecting higher growth in the future as compared with stocks that have a lower P/E. But on the other hand, a low P/E can also indicate that a stock is underpriced. The P/E ratio can be an informative metric, but you might not want to use it as a stand-alone indicator. Instead, consider combining it with other valuation metrics that can analyze the same asset but from different angles.
P/E ratio = stock price / earnings per share

Price/earnings-to-growth or PEG ratio: The PEG ratio is designed to measure a stock’s price in relation to its growth rate. The lower the PEG, the more underpriced a stock might be in relation to forecasted growth. Overall, viewing a stock’s P/E along with its PEG ratio may provide a more complete and well-rounded picture.
PEG ratio = P/E ratio / earnings growth rate

Price-to-book ratio: The price-to-book ratio compares the price of a company’s stock to the value of its net assets (minus liabilities). It’s important to understand that a stock’s price can reflect forward-looking expectations of a company’s future cash flows. Book value, on the other hand, is a strict accounting of a company’s current net asset values. It’s the difference between what’s on hand now versus what investors might be expecting in the future. So, a lower price-to-book ratio might sometimes indicate that a stock is at or below a reasonable valuation.  
P/B ratio = market price per share / book value per share

 

Seeking Portfolio Durability and Growth Through Value Investing

During periods of market turmoil, diversification has generally been regarded as one of the more effective means to reduce portfolio risk. Adding a value approach to the mix in some cases might even enhance the potential effects of diversification in terms of seeking durability and growth potential.

Maintaining a diversified portfolio of stocks that are trading below their fair value may help investors avoid some of the violent corrections that often follow strong rallies in overpriced stocks.

So although avoiding overpriced stocks at the height of a market rally may help reduce  drawdowns—hence making a portfolio more “durable”—buying underpriced stocks during market declines may be an effective way to position your portfolio for growth once the market turns toward the upside.

Pursuing both of these goals—durability and growth potential—is more or less what value investing is all about.

Image sourced from Pixabay

Information from TDA is not intended to be investment advice or construed as a recommendation or endorsement of any particular investment or investment strategy, and is for illustrative purposes only. Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade.

 

Related Articles

View Comments and Join the Discussion!

Posted-In: Portfolio Asset Management TDAmeritrade value stocksNews Markets Personal Finance General

Don't Miss Any Updates!
News Directly in Your Inbox
Subscribe to:
Benzinga Premarket Activity
Get pre-market outlook, mid-day update and after-market roundup emails in your inbox.
Market in 5 Minutes
Everything you need to know about the market - quick & easy.
Daily Analyst Rating
A summary of each day’s top rating changes from sell-side analysts on the street.
Fintech Focus
A daily collection of all things fintech, interesting developments and market updates.
Thank You

Thank you for subscribing! If you have any questions feel free to call us at 1-877-440-ZING or email us at vipaccounts@benzinga.com