Investing Today

By Dan Hreha

The inclusion of stocks in a portfolio is essential to meet most financial goals because historically, equities have outperformed all types of bonds and cash-equivalent securities over the long term, and their higher returns help combat inflation.

Sharp price swings in stocks due to market volatility can cause even the most disciplined investors to become jittery and unload their portfolios. In a turbulent market environment, investors looking for the growth potential that equities provide—with a lower level of principal risk—often find value stocks appealing.

Value stocks are those that are perceived to be “bargains” or are undervalued, that is, those whose true values are not reflected in their current prices and, over time, whose prices are expected to increase faster than stocks that are fully priced. Value stocks tend to be inexpensive or “cheap” compared to what they are currently worth. The market is not willing to pay more for them because their underlying companies or industries are out of favor. The job of value investment managers is to identify companies poised for a turnaround, potentially leading to rising earnings and higher stock prices.

Before investment managers identify a value stock as a “buy,” they must determine if a positive change has occurred in the underlying company that has yet to materialize in the stock’s current price.

Positive changes include:

• An aggressive management change or significant productivity improvements.

• A restructuring to reduce costs, which would make the company more likely to continue profitability over the long term.

• Financial conditions that are strong or improving.

Quality is also important in value stock selection. Strong balance sheets, long-term consistent operating histories and experienced, proven management dedicated to heightening shareholder value are among the fundamental criteria value managers look for when choosing individual value stocks.

Value managers generally use a “buy and hold” strategy, meaning a stock will be held until it meets its target price, and in some cases, even longer if the underlying company demonstrates the potential for continued profitability. Value managers will sell stocks that appear overvalued or have experienced deteriorating fundamentals.

Typically, large company value stocks are more attractive than small company value stocks during times of market volatility because these stocks are from companies that are established market or industry leaders. Therefore, they generally withstand market setbacks better than small cap stocks and experience smaller price swings during market volatility.

Of course, like all stocks, large company value stocks are subject to market risk and will undergo fluctuations in stock prices; downward (as well as upward) trends can occur over short or extended periods.

In addition to capital appreciation, value stocks typically pay investors a steady stream of income through dividends, although dividends are not guaranteed.

Dividends provide:

Cash return to the investor. Dividends are a major reason to invest in stocks at any point in the stock market cycle. Stocks that pay attractive dividends are appealing since they offer the potential for above-average growth of investment capital and steady income.

Downside protection. High dividend yields of underlying companies can serve as a “cushion” for companies’ share prices if they temporarily fall out of favor with the market. This protection plays an even more important role in volatile or declining markets.

Value stocks are especially appealing in turbulent times because they tend to be more defensive than other equity styles. Many conservative investors, those nearing retirement and first-time stock investors, find them attractive because they allow investors to participate in the larger gains associated with stocks while helping to manage risk.

While value stocks can play a valuable role in any investor’s portfolio, selecting those stocks appropriate for your investment plan is a demanding process that requires the inclination and time to analyze companies, study the forces that influence the economy and assess the trends in the financial markets. In volatile markets, this challenge can prove even more daunting.

A professional management program can be the appropriate strategy for building a portfolio of value stocks.

Dan Hreha is a financial advisor with UBS Financial Services in Charleston. E-mail him at dan.hreha@ubs.com.

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