Market Insights

Value stocks have gained popularity this month as investors look for vaccines to end the coronavirus pandemic. This article will consider key things to know:

• What are value stocks?
• Why are they going up?
• How do I find value stocks?
• Are value stocks good investments?

What Are Value Stocks?

Value stocks are equities that may appear inexpensive by various metrics. Investors may want to own them based on the idea their prices will return to “correct” values. They may not care whether their businesses are growing, or the long-term prospects of the industry.

Growth stocks, in contrast, are companies whose markets are increasing. They’re usually in newer fields where products and services haven’t yet reached all potential customers. (Like technology.) Growth stocks usually trade at higher prices, so they wouldn’t be considered undervalued.

Recent examples of value stocks include energy, industrial and financial stocks. Growth stocks include software companies, e-commerce and biotechnology.

Why Are Value Stocks Going Up?

Value stocks have gained recently because investors think the economy may recover from the coronavirus pandemic. They see the potential for fiscal stimulus to boost hiring and business spending. Hopes of at least one effective vaccine have people thinking travel restrictions and social-distancing measures could end soon.

Most value stocks fell sharply when coronavirus pushed the economy into recession. Investors shifted to companies that would benefit from social-distancing and remote work. Those included e-commerce, streaming video and software companies. They’ve mostly paused in the last month as sentiment shifted toward reopening.

How Do I Find Value Stocks?

Investors can find value stocks by scanning for companies based on certain ratios and metrics. They include:

• Price / book value is a company’s market capitalization divided by its book value. Book value is the difference between all the company’s assets and all of its liabilities. It’s also known as shareholder equity. Companies with low price / book values may be considered bargains.
• Price / earnings is a company’s stock price divided by per-share earnings. Also known as P/E ratio, this is the most common metric for valuing stocks. One limitation of P/E ratios is that they only work when companies have positive earnings. (Many beaten-down companies may have had losses recently.)
• Enterprise value / EBITDA compares a company’s enterprise value by its earnings before interest, taxes, depreciation and amortization (EBITDA). Enterprise value is a company’s market cap plus debt, minus cash. This accounts for assets financed with debt. For example, a company may purchase a building with cash on hand or borrow. The two scenarios will produce different market capitalizations and book values, but the same enterprise value.
  EBITDA measures the company’s ability to generate cash. This can be used to pay lenders or dividends (depending on how much debt it has). EV / EBITDA is commonly used when assessing takeovers and leveraged buyouts.
• Dividend yield is a company’s annual dividend / price. Higher values suggest a stock is inexpensive relative to its cash distributions. However, investors should realize that management can lower dividends without warning.

Are Value Stocks Good Investments?

Investors should always consider their time horizons, risk thresholds and expectations when making portfolio decisions. Recent gains in value stocks are based on the economy recovering and the coronavirus pandemic lifting. They also result from money managers rebuilding positions after liquidating these assets earlier in the year.

While the snapback could be sharp, its duration may be limited. Many impacted industries, like hotels, airlines and fossil fuels, may never return to their previous size. They could also be susceptible to political risk if Congress fails to pass further stimulus early next year.

Value stocks have at least two other potential drawbacks. First, their end markets are often mature or shrinking. Second, they don’t stand to benefit from disruptive technological innovation. This could make them less suitable for investors with multiyear time horizons.