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Investing with the Expensive Stock Market

Tuesday, October 10th, 2017

Value investing has been a proven strategy throughout history. This type of investing has produced an average annualized return of 13.5% dating back to 1927. This outpaces the average annualized return for growth stocks of 9.2% and the average annualized return for the S&P 500 index of 9.9%. The problem investors face is value investing goes through periods of underperformance and investors impatience drive them to chase recent strong performers. This has been the case in recent years as growth investing in names such as Amazon and Netflix have driven up the valuations on the S&P 500 index.

The recent returns in high flying growth companies have led investors to participate in a herd mentality. This means as investors watch the price move higher and higher for companies they experience a concept known as “FOMO” or the fear of missing out. They see the past performance over the last 12 months and think it will continue even though they are clueless on the value they are getting for the company.

The enchantment of cool new technology and the allure of low fees for index investing have driven investors away from understanding what they are actually buying. In a recent study it was determined that just 10% of stocks being traded in today’s market are based on decisions driven by fundamental analysis.

The mindless purchasing of equities has been a documented historical problem a prime example of this was the Nifty Fifty. This group of fifty stocks were deemed one decision stocks. They gained this title because investors were supposed to be able to buy them once and hold them forever. The problem was the popularity drove investors to pay expensive valuations for these companies and the Nifty Fifty flopped in 1973.

The one decision stocks remind us an awful lot of the popular strategy of index investing today. Investors have flocked to passive investing because of the recent returns and the low fees. Many have no idea when it comes to the fundamentals of the index. In a Warren Buffet shareholder letter, he claimed, “The fact is that markets behave in ways, sometimes for a very long stretch, that are not linked to value. Sooner or later, though, value counts.”

When we talk about being value investors we look at 5 major valuation ratios: Price/Sales, Price/Book Value, Price/Earnings, Price/Cash Flow, and Price/Future Earnings. It is important to remember when you buy an equity you are buying a small piece of a large company.

Price/Sales is a very simple valuation to analyze. The other valuations can be somewhat distorted due to accounting, but this ratio cannot because sales are sales. The current Price/Sales ratio for the S&P 500 is 2.2. This is now higher than what we saw during the tech boom and it stands well above the near 20-year average of 1.5. At Wilsey Asset Management, the mean Price/Sales for companies on our buy list is 1.1.

Price/Book Value measure how much investors are paying for the equity of a company. Simply put, it is the assets minus the liabilities of a company and is like an individual’s net worth. The current Price/Book Value for the S&P 500 is 3.3, which is well above the average of 2.5 that dates to 1978. At Wilsey Asset Management, the mean Price/Book Value for companies on our buy list is 2.0.

Price/Cash Flow is another important measure we analyze. It is slightly different than earnings as accounting expenses could provide a cloudy picture for earnings. If a company is generating cash it can operate the business effectively, buy back stock, issue dividends, pay off debt, and invest in the future of the company. Cash Flow is crucial for a company and like the other valuation ratios, we want to make sure we aren’t overpaying for it. The current Price/Cash Flow for the S&P 500 is 14.0, which is well above the average of 10.5 that dates to 1986. At Wilsey Asset Management, the mean Price/Cash Flow for companies on our buy list is 7.9.

Price/Earnings is the most common valuation ratio investors refer to. It is important to make sure the company is generating a profit and as an investor you are not overpaying for your share of the earnings. When we analyze the earnings we always look at GAAP EPS because all companies must comply to the same regulations. The current GAAP Price/Earnings multiple for the S&P 500 is 23.6, which is well above the average of 19.1 that dates to 1960. At Wilsey Asset Management, the mean GAAP Price/Earnings for companies on our buy list is 12.1.

The traditional Price/Earnings measure that is analyzed looks at earnings over the last 12 months. While this is an important measure, we also want to look at the earnings moving forward to make sure we aren’t buying the next polaroid camera. Ironically, this was a Nifty Fifty company that cost many investors a lot of money. When we look at the forward consensus P/E for the S&P 500 it is nearing 18. That is above the 40-year average of 16.5. At Wilsey Asset Management, the mean forward P/E for companies on our buy list is 11.0.

While it takes time to find value companies with strong balance sheets, it is a prudent strategy given the expensive state of the market. It is important to note that while the broader based market is expensive, there are individual companies that are still trading at attractive valuations.

Do you have a question or a company you would like us to take a look at?
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