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Retired Investors: Apply A Value Investing Strategy And Earn More Income And Higher Returns

Value investing produces safe, powerful long-term results but it is often misunderstood.

Investing in undervalued stocks turbo-charges long-term returns.

Value investing exploits the disconnect between stock price and fundamental value.

Value investing is a long-term strategy requiring intelligent patience.

Undervaluation happens when a stock temporarily becomes unpopular.

Value investing produces safe, powerful long-term results, but it is often misunderstood. This is why most of the greatest investors that have ever lived have employed some form of value investing as an integral part of their overall stock investing strategy. However, the term, concept or strategy called value investing does not necessarily universally apply. Like many financial terms and concepts, there are many nuances that pertain to the general concept of investing for value in common stocks.

On the other hand, there is some common ground that theoretically applies to all value investing approaches. At the core, value investors are looking for investment opportunities in companies that they believe the market is currently undervaluing. Additionally, most value investing strategies are attempting to exploit disconnects that occasionally occur between a company's stock price and its true underlying fundamental value.

This article will present value investing strategies that apply primarily to investing in dividend growth stocks. Although all value investing implies investing in a business below its true worth, the calculation of fair value can differ significantly between various types of common stocks. For example, a fast-growing true growth stock will command a different level of fair valuation than a slower growing dividend paying company. Although the underlying principle of value applies to both, the calculation of fair value will be materially different.

Successful Value Investing Requires a Long-Term View

An important attribute shared by most value investing approaches is the rational perspective of taking a long-term view. This is critically important, because it is all too common that undervalued common stock investments do not tend to perform well over the short run. This is simply because, as a general rule, you will not find undervalued investment opportunities in popular stocks (companies). Common sense dictates that stocks only tend to become undervalued when they are simultaneously unpopular, at least temporarily. It is generally this unpopularity that creates the short-term discrepancy between fundamental value and stock price.

However, the greatest success derived from value investing happens when the company's stock price is dropping even when the fundamentals of the company continue to remain strong. Therefore, the key to implementing a profitable value investing transaction is to learn to focus on and trust the fundamentals supporting the business. In the same context, this further means adopting the conviction to not trust, and even the willingness to ignore poor short-term price action. Accomplished value investors understand that stock prices can lie, at least over the short run. But more importantly, accomplished value investors also understand that in the long run, fundamentals matter most.

Consequently, successful value investing requires a level of patience that unfortunately many short-term oriented investors do not possess. However, the rewards from investing in a truly undervalued stock can produce powerful long-term returns for the rational value investor who is capable of engaging in intelligent patience. But even better yet, those powerful long-term returns are generated at reduced levels of risk relative to other common stock investing strategies.

On the other hand, value investing does not eliminate all the risk or risks associated with common stock investing. But, if engaged in properly, value investing does significantly mitigate or reduce the risks to a more than acceptable level. Importantly, this last point also applies to investing in the same individual stock at different levels of valuation. In other words, if you overpay for even the best company, you thereby add a level of risk that is not innate to the fundamental strength of the business itself. In contrast, by investing in the same company when it is undervalued will reduce the risk of owning it, and simultaneously add a turbo-charger of sorts to your future long-term results.

The turbo-charger I am alluding to refers to the tendency of stock prices that have disconnected from fundamental value to inevitably move back to alignment with intrinsic value in the long run. In other words, when a stock is overvalued, it will inevitably move back into alignment with its fundamental value. Unfortunately, the precise timing of that movement is unpredictable, and can take longer than many people expect. This principle can cause investors in overvalued stocks to lose capital long-term, even when the company remains fundamentally strong.

In contrast, when a stock is undervalued, it will also inevitably move back into alignment with its true worth in the long run. Again, the precise timing is unpredictable and can even take longer than many investors are willing to tolerate. Regardless, the value investor not only receives financial rewards from the fundamental strength and/or growth produced by the company's business results, they also receive accelerated rewards from future P/E ratio expansion.

There is a great misconception and even criticism that alleges that value investors do not care about capital appreciation or total return. Although it is true that accomplished value investors will ignore short-term price volatility (losses), this does not mean that they don't care about making a profit. On the other hand, it does mean that they do not worry very much about short-term price volatility, but only when they have determined through research that it is unjustified.

Accomplished value investors understand that long-term investment results are functionally related to the success of the business behind the stock. Therefore, they focus more on fundamentals such as earnings, cash flows and dividends (if the company pays one). As long as fundamentals are strong, they are confident that this strength will eventually be reflected in higher future stock values. Frankly, I have never seen a situation where that confidence was not justified in the long run, as long as fundamentals remain intact.

In summary, value investors care deeply about capital appreciation and total return. However, they are willing to wait patiently for it to happen as long as the fundamentals of the company they purchase remain solid, and better yet - continue to grow. But perhaps more to the point, value investors are not expecting poor long-term returns when they invest in an undervalued stock, quite the contrary. Value investors expect outsized long-term returns resulting from purchasing a stock at a bargain valuation. But best of all, they will get them as long as they are patient enough.

The following F.A.S.T. Graphs look at Northrop Grumman based on the important fundamentals earnings and dividends only since 2008. Just as it was for most publicly traded US corporations, Northrop Grumman produced a down earnings year in 2009 (The Great Recession). However, it's important to point out a few critical factors. First, the company was not losing money , in fact, remained highly profitable. Second, they remained profitable enough for management to have the confidence to raise their dividend by 8% in 2009.

Additionally, a weak 2009 lead to an incredibly strong 2010...