Value stocks are, as the name suggests, a core feature of value investing. As value investors, we want to buy stocks for less than what they’re actually worth.
It sounds simple. If we could buy £80 for £100, we’d do it right? The thing is, the market doesn’t always work the way we think it should and valuations can be subjective.
Secrets of value investing
Warren Buffett is among the most successful investors of the modern era. His strategy is value. With a net worth in excess of $100bn, it’s no wonder that novice investors are increasingly interested in Buffett’s strategy and in value investing.
The so-called Oracle of Omaha tells us that we need to find a margin of safety if we want to invest in value. And we do this by purchasing stocks that appear to be trading for less than their intrinsic or book value. Buffett is known to look for a margin of safety up to 50%.
Finding these stocks can be the challenging part. It requires us to assess what we think stocks should be valued at. We can use near-term valuations such as the price-to-earnings ratio and the EV-to-EBITDA figure, and compare them against industry peers.
Or we can run models such as the discounted cash flow model (DCF) — this tends to be a more thorough approach.
Value picks
Obviously, we can all invest like Buffett through buying Berkshire Hathaway stock — that’s the investment firm he has run for five decades. But it’s listed in dollars, and currency fluctuations could wipe out our gains.
Instead, I’m looking at two British banking stocks.
Barclays (LSE:BARC)
- Price-to-earnings: 5.4
- DCF: undervalued by as much as 70%
- Dividend yield: 4.5%
Barclays is among the most unloved stocks on the blue-chip index. But banks are also cyclical, meaning they tend to perform well when the economy is strong, but poorly when the economy is weak.
The current picture is somewhat mixed, interest income is high, but so are impairment charges. I’m investing for the medium term when we should see interest rates fall and economic growth — hopefully — normalise.
Banks thrive when interest rates are elevated, but not too high — around 2%-3%. The best is yet to come.
Lloyds (LSE:LLOY)
- Price-to-earnings: 6.5
- DCF: undervalued by as much as 51%
- Dividend yield: 5.1%
Lloyds is more interest-rate-sensitive than Barclays. That’s because it doesn’t have an investment arm and because of its funding composition.
Yet like Barclays, higher interest rates have positive and negative consequences — higher net interest income, but higher impairment charges.
If BoE interest rates move upwards to 5.5%, that will likely have a profound impact on bad debt at Lloyds. After all, mortgage repayments (mortgages account for around 60%-70% of the loan book) will soar. Some homeowners won’t be able to make these repayments.
However, once again, Lloyds should prosper in the medium term, with higher economic growth and moderate interest rates.
