Value Stock

A value stock is a share of common stock trading at a price that looks low measured against what the company earns, owns or has historically been worth. Nothing about the security differs from any other share. What differs is the reason for holding it: the buyer thinks the price understates the business.

FINRA's investor education states both halves of the idea together. Value stocks "are investments selling at what seem to be low prices given their history and market share," and "if you buy a value stock, it's because you believe that it's worth more than its current price." Then the caveat, which belongs in the definition rather than in a footnote: "it's also possible that investors are avoiding a company and its stock for good reasons and that the price is a fairer reflection of its value than you think."

A naming point. "Value investing" and "value stock" name one subject from two directions, and FINRA teaches them under a single heading alongside growth. The strategy is holding more of these companies than a broad market fund would, so this page covers the classification and what acting on it involves.

The premise is a disagreement with the market, and it needs to be stated that way to be assessed. Buying a value stock means concluding that a price visible to everyone is too low. The seller on the other side of that trade has the same filings and the same price and has reached the opposite conclusion. So the position is not "this company is sound" but "the market has mispriced this company," which is a considerably stronger claim and the one that has to be right for the holding to work.

The value trap is the failure mode, and it is not a rare one. A price can be low because the market is wrong, or because the market has correctly noticed that earnings are shrinking, an industry is being displaced, or a balance sheet is strained. Both look identical on a screen that ranks by price against past earnings, because the screen reads yesterday's earnings and today's price. This is why measures that appear cheap can keep appearing cheap for years while the shares fall further, and why FINRA's caveat is the operative sentence rather than a disclaimer.

What "cheap" is measured against. In practice the screens use ratios that compare price with something the company produces or holds: earnings per share, book value, cash flow, or the dividend. Each has its own weaknesses and each belongs with its own term. The point that survives all of them is that every such ratio has the price on top, so a falling price makes a stock look cheaper on every one of them at exactly the moment the business may be deteriorating.

Contrarian investing is the deliberate version, and FINRA is explicit about what it takes. If you buy stocks that are out of fashion and sell stocks other investors are buying, FINRA says, you are a contrarian investor. It attaches a warning: "contrarian investing requires considerable experience and a strong tolerance for risk, since it may involve buying the stocks of companies that are in trouble and selling stocks of companies that other investors are favoring." Note what the tolerance is for. The difficulty is not analytical so much as behavioral, since the position is by construction unpopular and can stay unpopular for a long time.

There is no definition to look up. The SEC's investor glossary has no entry for it and FINRA describes it rather than setting a test. As with growth, what exists instead is the SEC's fund names rule, which treats "value" as a term suggesting an investment focus and requires a fund using it to adopt a policy of investing at least 80% of its assets in accordance with its own stated definition. So the definition sits in each fund's documents, and two honestly labeled value funds can screen on different measures and hold different companies. The mechanics of that rule are set out with growth stocks.

The portfolio question is separate. A broad market fund weighted by company size already holds these companies at the weight the market gives them. A dedicated value fund holds more of them than that, which is an active decision requiring an active reason.

A screen ranks companies by one or more ratios comparing the share price with something the company produces or owns. The companies that look cheapest are classed as value stocks. An investor or a fund buys them and waits for the price to rise toward what the buyer believes the business is worth, which may take years and may not happen.

A hypothetical illustration of why a falling price is not the same as a bargain. Cortez looks at a company whose shares trade at $60 and which earned $5.00 per share last year. The price-to-earnings ratio, the share price divided by earnings per share, is 12 ($60 divided by $5.00).

Over the next two years the shares fall to $25, which is a decline of more than half, and the company's earnings fall to $1.50 per share. The ratio is now 16.7 ($25 divided by $1.50). The stock costs far less than it did and is more expensive by this measure than it was, because the earnings fell further than the price did.

That is the shape of a value trap. A screen run on last year's earnings and today's price would have called the shares cheap on the way down, and the question the screen cannot answer is whether $1.50 is a temporary low or the new normal. All figures are illustrative.

Pros

• The judgment rests on published financial statements rather than on forecasts of what has not happened yet.
• Paying less for the same earnings leaves more room for a disappointing result before the position becomes a loss.
• Value companies are more likely than growth companies to pay dividends, so part of the return can arrive without selling.
• The unpopularity that creates the price is a real source of opportunity when it reflects sentiment rather than the business.

Cons

• The market may simply be right, and FINRA says so directly. A low price can be a fair reflection of a deteriorating business.
• Every common ratio puts price on top, so a falling stock looks cheaper on all of them at exactly the wrong moment.
• The position can stay unpopular for years, and FINRA notes that contrarian investing requires considerable experience and a strong tolerance for risk.
• The SEC's glossary has no entry and FINRA describes rather than defines, so two value funds can screen differently and hold different companies.
• A broad market fund already holds these companies at market weight, so a dedicated fund is an active bet rather than an added exposure.