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When investing to make money in stocks or mutual funds, you have a choice of two fundamental approaches: growth investing or value investing.
Growth-stock companies are ones with higher-than-average gains in earnings over the past few years, which you hope will continue to deliver strong profit growth down the road (of course, there are no guarantees). Or there are ‘emerging’ growth companies that have the potential to attain high earnings growth though they do not have a history of this profitability yet.
On the other hand, value stock investing involves looking for purchases that are currently undervalued by the marketplace but have a reasonable likelihood of getting a better, more realistic valuation down the road.
Of the two approaches, value stock investing may seem a little riskier because you're investing in something whose intrinsic worth is unknown but you believe will pay off later. It requires a certain confidence and a willingness to make decisions on your own, apart from the crowd.
That being said, the value investing world has attracted some of the most successful investors. For example, investment guru and business mogul Warren Buffet who is known for his success in buying and reaping the benefits of undervalued stocks. So you would be keeping good company with this approach.
With value stock investing, you are looking for companies that may be trading lower because of the natural fluctuations of the market, or they have fallen temporarily out of favor, or they may be new that have strong potential. Though underperforming now, these investments have rock-solid fundamentals – or ‘intrinsic value.’
The principle is simple. If you know a widget is worth $100, and you see on sale for $64, you buy it and sell it later when it reaches its true value in the market, pocketing a $36 profit.
The $36 is your margin of safety, providing you some protection in case the widget (or stock) doesn’t perform as expected. Also, by analyzing the undervalued stock’s intrinsic value – through financial statements and fundamentals, like cash flow, retaining profits, return on assets and capital management – you know that it is unlikely the stock’s value will further plunge like speculative stocks.
Generally speaking, value investments tend to have lower prices than the broader market, carry less risk and are priced below similar companies in the same industry.
Following a value stock investing strategy requires patience and courage – you often have to hold on to your investment when others are selling, or sell when they are holding back. You need to be sure in your valuation of a company’s true worth and have faith the market will take it there eventually.
You can’t follow the herd but must blaze your own path.
You avoid popular stocks that are the flavor of the day and go for the ones that are undervalued but have the fundamentals in place. You know that if a company offers a valuable product or service, it can overcome temporary setbacks.
Value investors also do not embrace the efficient market hypothesis, an investment theory that believes that stock prices already reflect their true value, because they take into account all pertinent information about a company. Value investors believe that because of market conditions a stock can be overpriced or underpriced.
Finally, value stock investing isn't about short-term gains, it's about having a long-term strategy. You must have patience and discipline when waiting for your investment to pay off, and this process can sometimes take years.
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