The perennial debate over growth versus value investing has captivated investors’ minds for decades and kept free stock scanners busy. While both strategies have their moments in the sun, high interest rate environments tend to favor the value investing approach. In this article, we will discuss why this is the case, and how you can identify the best value stocks at a given time.
Interest rates as a key valuation parameter
To manage a portfolio through the different cycles, it is important to have a basic understanding of the principles of stock valuation. One of the most widely used stock valuation methodologies is the concept of discounted cash flows (DCF). When determining a company’s (intrinsic) value, future profits or cash flows are projected and then discounted back to their present value using a discount rate. Elevated interest rates tend to increase this discount rate, making future earnings less valuable in today’s terms.
Growth stocks’ earnings potential tends to be further out into the future than the profits of established companies with proven business models. Distant profits therefore shrink considerably when discounted at a high rate. Inversely, value stocks with a long track record of profits, who became undervalued due to limited growth prospects, start to look more attractive.
Plenty of empirical evidence
Numerous academic and industry studies have examined the relationship between value and growth stocks and various economic factors, including interest rates. In a frequently referenced paper titled “High interest rates and the value premium” Binying Zhang investigates the relationship between the value premium (the return difference between value and growth stocks) and interest rates. His work demonstrates that the value premium is higher during periods of high real interest rates.
How to find great value stocks using a free stock scanner
Discovering genuine value stocks in any market environment requires diligence and a disciplined approach. These are some of the key measures to look at when looking for value stocks through a stock research tool, such as a free stock scanner:
Price-to-Earnings (P/E) ratio
The most common indicator to start the screening process with is the Price-to-Earnings (P/E) ratio. This ratio indicates how much investors are willing to pay for every dollar of a company’s earnings. These earnings can be past (trailing P/E ratio) or future (forward P/E ratio). A low P/E ratio compared to industry peers or the stock’s historical average might suggest undervaluation.
Book Value
Subtracting a company’s liabilities from its total assets yields its book value. When a stock’s market price is lower than its book value per share, it can be a signal that the stock is undervalued. This metric is particularly useful for sectors like finance, where assets play a critical role.
Price-to-Sales (P/S)
The Price-to-Sales (P/S) ratio is another standard metric found in many free stock scanners. It is used to gauge the valuation of a company by representing the coefficient of a company’s market valuation and its sales. The P/S ratio can be a useful alternative when comparing unprofitable companies, as earnings-based ratios (like P/E) will not be meaningful. It’s also a more stable coefficient as sales figures tend to be less volatile than earnings.
Best stock scanner hack
Our free stock scanner comes with a very powerful built-in hack. Screening by Valuation Score allows you to capture five principal valuation metrics in one. What’s more is that these built-in metrics are specific to industries. For instance, in the case of banks, we will not use book value, but tangible book value. You can learn more about the Ziggma Stock Scores here.
The valuation score is normalized on a scale of 0 – 100. The higher it is, the better a company ranks versus its peers.
Compare against peers in your stock research
Once your screen has produced a certain number of value stocks, be sure to compare them on additional parameters, such as growth, profitability and financial situation. Sure, you want a great deal and get into a stock at an attractive price level. But, it’s crucial that you make sure that you don’t walk into a value trap. Here are some additional boxes your stocks should check:
1 – Growth: You want to stay away from companies whose revenue is projected to drop.
2 – Profitability: Stick to companies whose margins are on an upward trend.
3 – Financial situation: Filter out companies with excessive debt and financial leverage.
Industry Trends and Comparisons
Sometimes entire industries fall out of favor with investors, leading to potential undervaluation across the board. Comparing companies within an industry can help discern which ones are genuinely undervalued and not just part of a broader downtrend.
Industry Trends and Comparisons
Sometimes entire industries fall out of favor with investors, leading to potential undervaluation across the board. Comparing companies within an industry can help discern which ones are genuinely undervalued and not just part of a broader downtrend.
Tread with caution. There’s no golden rule
While the basic notion holds that value stocks tend to fare better in a high interest rate environment, investors must still be cautious in determining whether a stock that looks like a value stock truly is a value stock. For example, certain real estate stocks or utilities may look like inexpensive value plays. Yet, they may operate with high debt loads so that increasing interest rates are likely going to squeeze their bottom line as loans come up for refinancing.
Even through you are not a hedge fund manager, be mindful of the cycle
In conclusion, while both value and growth investing have their merits, high interest rate environments tend to shine a favorable light on value stocks. These stocks, grounded in current valuations rather than future potentials, offer a buffer against the negative effects of rising rates. To the contrary, valuations in high growth companies, especially unprofitable ones, will tend to get discounted the higher rates go.
As always, though, it’s essential to diversify investments, ensure they align with individual financial goals and monitor your investments over time with free tools, such as a portfolio tracker.