Buying Value Stocks Still Carries Substantial Risk

The definition of what a value stock varies among Morningstar, Lipper, the Investment Dictionary, Wikipedia, and other financial resources. However, generally speaking, a stock is considered a value stock if it is currently trading below its perceived price level. There are many mutual funds, money managers, and investment professionals that hold themselves out as value stock specialists. These individuals want investors or investment professionals to trust them to purchase stocks, which they perceive to be undervalued.

While value investing is widely followed investment discipline, when it comes to certain stocks, determining what the value should be can be risky. There are plenty of success stories out there where investment professionals buy stocks that get oversold on breaking news and eventually recover to profitability. In the last stock market sell off, many of these opportunities arose.

This is an art that professional money managers have been working to perfect for some time. Where retail investors get into trouble is when a retail stockbroker calls them up wanting to do the same thing. For every success story out there, there are just as many failures. At what point does a so-called value stock become a bankrupt company?

Stocks such as Enron, Lehman Brothers, Bear Sterns, Washington Mutual at one point in time were all purchased by retail brokers because they viewed these stocks as undervalued. Unfortunately, some times stocks are being sold for a reason. Institutional investors, banks, hedge funds and others were likely selling out their portfolios of these stocks while retail brokers were pushing them on to unsuspecting novices. Too often you will here statements in retail offices such as, “if I loved Bank of America at $14, why wouldn’t I love it at $7”. This mindset is the reason why retail investors are encouraged to double down on falling positions.

The only way to truly avoid buying a falling knife rather a diamond in the rough is to have a diversified portfolio with proper allocations to stocks and bonds depending on your investment time horizon, risk tolerance, and needs for the investments. Allowing a professional money manager to purchase small amounts of quality undervalued stocks for you, or purchasing a value mutual fund with a manager with a successful track record is significantly different than a retail broker encouraging you to double down. Investors should be wary of any retail broker recommending these types of strategies.