The Value-Focused Fund: Great Idea, Terrible Results

Value-focused funds are mutual funds that invest in undervalued stocks. They should not be confused with growth funds--mutual funds that invest in low-value stocks that have potential to become highly valuable in the future. The theory is that undervalued stocks are valuable all along--it's just that most investors don't realize it yet. Value-focused funds have a potential to yield high returns, outperforming growth stocks and many other types of mutual funds. However, value-focused funds are also incredibly risky. There are a number of factors that can cause the funds not to perform as predicted, leaving you with significant losses that may exceed whatever returns you hoped to get.

Understanding Value-Focused Funds

The stocks are considered undervalued if they are traded below their book value and have a low price-to-earning ratio. The book value is the value of the company's assets on the balance sheet. The price-to-earnings ratio is the ratio between the stock price and the value of the company's profits.

Investing in value-focused funds requires time and patience. That's because the main assumption behind such investing is that sooner or later, the markets will realize just how much the undervalued stocks are actually worth. When that happens, the prices will go up and you will be able to earn a profit.

While this sounds fairly straightforward, the reality is more complicated than that. As mentioned before, the value-focused funds carry certain inherent risks that make investing in them far less promising than it would seem at a first glance.

The Problems with Analyzing Undervalued Stocks

The biggest problem with value-focused funds lies in the very nature of undervalued stocks. Ideally, investors will be able to determine which stocks are undervalued by comparing stock value, the value of a company's assets and the value of a company's earnings. In reality, those numbers don't paint the whole picture--in fact,they can be manipulated to make the company's financial situation look better than it actually is.

A good investor will research the company thoroughly and carefully examine its finances. The problem is that the results of this research are open to interpretation. Different investors may come to different conclusions, and those conclusions may not necessarily be on the mark. The stock that you thought was undervalued could turn out to be valued exactly as it was supposed to be, so the profits you were anticipating may never materialize. Worse, the value may actually plummet. You may be tempted to try to ride it out and wait for the values to rise again, but this outcome is far from guaranteed. It can leave you trapped in a vicious cycle as you keep waiting for the prices to rise, while they continue to drop lower and lower. In the worst-case scenario, the company may wind up going out of business, leaving you with zero returns for your investment. 

The fact of the matter is that value-focused funds tend to do worst when the economy is declining or in recession. Under those conditions, the companies are especially vulnerable to financial failure. The situation is not helped by the fact that if you want to invest in this economic climate, other investors will prefer to be more cautious. As the result, the stock prices may not rise as high as they otherwise would--in fact, they may even drop further.

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