2 Myths About Value Investing Every Investor Should Know
Value investing is a concept most people hear about because of the popularity of billionaire investor Warren Buffett. They may know that value investing is something Buffett has used for decades to become one of the richest people on this planet. However, there are still many myths surrounding value investing and what it is truly about.
Here are two big myths that will bust.
Myth No.1: Great returns can only come from small companies
Many investors assume that market-beating returns can only come from investing in stocks with small market capitalisations. The reason is that in theory, small companies have a longer runway to grow compared to a large company.
But, that is a very dangerous assumption to have in the stock market. This is because large companies can still continue to show strong growth rates for extended periods of time if:
1) It is in a growing market.
2) It is expanding into other sectors
3) It is expanding into other geographical regions
There have been many examples of large companies producing market-beating returns for investors. Just recently, a technology giant became the largest listed company in the world after seeing its share price triple over the past four years. This means that the company has produced an average annual return of around 30% for its shareholders for the past four years.
Large companies can continue to grow much bigger in the future. This is because they have competed in their markets and proved that their business models work. On the other hand, a small company can easily continue to stay small due to its inability to compete effectively with other companies.
Myth No.2: An undervalued stock must carry low price-to-earnings (PE) and low price-to-book (PB) ratios
Value investing is about buying stocks that are undervalued. However, the interpretation of what “undervalued” means is debatable and highly misunderstood.
Too often, the term “undervalued” is linked with companies that have a low PE ratio and/or low PB ratio. In reality, it is not as simple. There are many reasons why a company might be trading at very low PE or PB ratios and yet not be undervalued. Some of such reasons for having a low PE ratio include:
1) Earnings that are inflated due to one-off events or other situations
2) The company has limited growth potential
3) The company has corporate governance issues
4) The company or industry is heading into a recession
Some of such reasons for a company to have a low PB ratio include:
1) Its asset value is inflated in relation to economic reality
2) The replacement cost of its assets is much lower than its stated accounting value
3) The company is underutilizing its assets
A Foolish summary
Value investing is a wonderful concept to know and put into practice in the stock market. However, due to the wide range of views about what value investing really is, there have been many myths that can potentially damage investors’ returns being spread about it. What I’ve shared above are two common and important misconceptions investors have about value investing.