Value investors seek out and invest in undervalued stocks in the market. “Undervalued” simply means that those “value stocks” trade below their intrinsic value — the actual worth of a business. That mispricing — a stock’s price trading below its intrinsic value — can occur for a variety of reasons, namely sentiment, perception, unusual or short-term events, and broad market declines. Intrinsic value is a culmination of a company’s brands, tangibles, intangibles, future earnings, and competitive advantage, among other things. Intrinsic value is seen as a better gauge of a company’s worth than merely its book value (assets less liabilities), which doesn’t adequately account for the true worth of a company.
Value investors invest in these undervalued, or mispriced, value stocks, in the anticipation that their market prices will revert to their mean or go back to their intrinsic value. But inherent in value investing is the risk that reversion to the mean does not occur in a short time frame and the stock’s market price may continue to decline or be volatile. The biggest
risk, though, is what is referred to as a value trap, in which a value investor misjudges a stock’s intrinsic value, such that the company’s fundamentals completely deteriorate and, in effect, validate the stock’s lower price. For this reason, value investors must identify a catalyst (for example, a change in management) or a set of catalysts in each value stock to determine whether they will actually revert back to their intrinsic value.
Robin Speziale is the national bestselling author of Market Masters, which is available at Chapters, Indigo, and Coles as well as Costco and Amazon.ca. He lives in Toronto, Ontario. Learn more about Market Masters.