Investment Basics

Many of the world's most successful investors consider themselves value investors. But what is value investing, exactly? For most of us, value investing means purchasing value stocks as part of our long-term approach to equity portfolio management. The key here is to purchase value stocks, but what defines a value stock? After all, there is a fine line between a value stock and a stock that is out of favor for a good reason. At one time, the "old" GM stock would have fallen under the traditional definition of a value stock; within months, the "old" company was bankrupt and its stock was worthless.

On the other hand, some of the best performing professional money managers overlook value investment pools. Data available at Morningstar points to a clear trend among domestic mutual funds that invest in equities: the value investments are the best performing among the three market capitalization classes. This is worthy of anyone's attention, so let's take a look at what a value stock is.

The traditional definition of a value stock is one that is trading at lower Price to Earnings (or PE) multiples than the market average. That is to say that if ABC Stock is trading at a PE multiple of 11 and the broader market's average PE is 19, ABC Stock is a value stock. The general belief among value investors is that these stocks have been over-sold by emotional investors. A missed quarterly earnings result, a bad management decision and a host of other touchy events can trigger mass selling of a stock, even though that single event may not reflect the future potential of a given company. This is the premise by which many value investors trade.

However, low PE multiples and a strong belief in a company's long-term prospects do not always guarantee success. As mentioned in the GM example, some value stocks are properly priced as a result of fundamentals (in fact, General Motors was bankrupt on paper long before its stock price reflected this). Still, General Motors survived thanks to a massive bailout and has re-listed its shares, leaving old shareholder's "burnt" by what might have seemed like a smart "value investment" at one time.

With this in mind, value investments typically require the investor to take on a little more risk than with straight "growth" investments. And this risk, while it has rewarded investors handsomely over the past several years, is not always worth the investment.

--> Consider Value Mutual Funds as an alternative to hand-selecting the value component of your portfolio.

Chris has more than 18 years of financial services experience. He currently manages as a website about GeForce video cards, including a page about the GeForce GTX 480 at EVGAGeForce.com.