Why Should I Invest in Lower End Value Stocks?

Buying low and selling high exemplifies the low-end value stock approach.

Duncan Smith/Photodisc/Getty Images

Value stocks sell at an undervalued price relative to the issuing company's financial performance and the performance of the stock's industry sector. Such stocks typically have a low price-to-book ratio and low price-to-earnings ratio. That means the company's earnings might justify a higher price. Lower-end value stocks carry typically carry a very low price-to-earnings ratio. When you buy such a stock, you're saying the investing crowd is wrong, based on your evaluation of cash flow, profits and sales growth.

Price Appreciation

A May 2011 article in "Kiplinger" magazine cites data showing that value stocks outperformed growth stocks during the previous 81 years. The article says large-cap value stocks returned an average of about 11% annualized, compared with 9% for growth stocks. For small caps, the difference was even greater: 14% annualized for value stocks and 9% for growth stocks. And according to an October 2011 article in "The Wall Street Journal," long-term investing favors value stocks. That article cites data showing that "the cheapest one-tenth of U.S. stocks relative to projected earnings have outperformed the most expensive one-tenth by 9.1 percentage points a year on average since 1968."

Seeing the Potential

When there are negative headlines about a company, such as when it loses an important client or goes through an unexpected management shakeup, its stock price usually declines. This is the case even if the company continues to produce strong sales and profit growth. Low-end value stocks often get that way due to an overreaction to bad news. If you buy when the stock price is low, you have a chance to make earn a tidy profit when investors realize their error and push the price back up again.

Investment Bargain Shopping

Even though data show that value stocks have produced good returns through the years, it helps to have specific reasons to buy a lower-end value stock. Your reasons should include not only the potential for higher-than-average profits, but a fundamental conviction that the issuing company has strong growth possibilities. This requires you to see developments that other investors do not. That's why the low-end value stock is at the low end in the first place. For example, if an out-of-favor company has had years of growing profits but has recently shown little profit growth, you might review and evaluate management statements and see if you think the company has sound plans to address the profit slowdown. To give another example, if a company recently reduced its dividend, you might determine that this was a cost-cutting strategy that will eventually make the company stronger. Such insights provide good reasons to buy a low-end value stock.

Free Guidance

You can get guidance for picking lower-end value stocks by researching websites that list the holdings of mutual funds that specialize in value stocks. For example, TheStreet.com regularly lists the top 20 value funds, and U.S. News and World Report ranks the largest value funds. These sites list the stocks that such funds hold and also tell you the fund's average annual returns and expenses. By examining a value fund's holdings, you can create a list of stocks to study for yourself. You will have to use your own criteria to determine which of those stocks qualify as low-end value stocks.