Weathering 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 withstanding trading instability better than your peers.
This is one core principle 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 it might also be susceptible to higher volatility, which can drag down the "durability" of a portfolio.
Below are 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 here, sometimes a stock looks cheap, but because of deteriorating fundamentals or a weak outlook, it's 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 majority of stocks see their prices decline. In such an environment, growth stocks can get hit particularly hard.
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 an investor create a durable portfolio? By holding fundamentally sound stocks that aren't greatly overpriced by some of the metrics described below. In short, by holding "value stocks," an investor might be able to reduce the level of drawdowns in their portfolio, achieving a relative degree of durability because 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 believed to be worth more, according to fundamental criteria like 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 strategy 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, we mean 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 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 (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 investors expect higher growth in the future compared to stocks with a lower P/E. 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 investors might not want to use it as a stand-alone indicator. Instead, investors should 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 (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 (P/B) ratio
The P/B 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 P/B ratio might indicate 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 effective means to reduce portfolio risk. Adding a value approach to an investor's strategy 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 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 up.
Pursuing both of these goals—durability and growth potential—is more or less what value investing is all about.
All investing involves risk, including the possible loss of principal. Asset allocation and diversification do not eliminate the risk of experiencing investment losses.
This material is intended for informational purposes only and should not be considered a personalized recommendation or investment advice. Investors should review investment strategies for their own particular situations before making any investment decisions.0223-30KW