Mail Bag: Buying Stock When Valuations Are High
Here’s a mail bag question about investing when stock market prices are elevated.
What are your thoughts about periods when overall stock market valuations look very high? Should people not buy, or should people even sell? It seems like today is a time when most valuation measures show the U.S. market at extreme highs relative to history. What are your thoughts?
Although I’ve written about reasons people don’t sell stock during crashes and reasons people don’t sell overvalued stock, this is a bit of a different question. It gets more to the heart of the matter of portfolio management. For you to understand my answer, you need to take a step back with me for a moment and look at the entire picture; at least how I see it.
When you decide to buy or sell an ownership stake in a business through the publicly traded securities markets, you are most likely using one of three approaches:
- Valuation: Acquiring ownership by comparing the price you are paying for that ownership to either the underlying assets, net present value of discounted cash flows, or strategic value to some other existing operation in which you are engaged. Regardless of what the stock market does in the short-term, your ultimate performance wagon is hitched to the underlying intrinsic value produced in one capacity or another from the enterprise.
- Systematic Purchases: Acquiring ownership through regular, disciplined purchases (in the olden days, this was called “formula investing”). You might have money swept out of your bank account twice a month to participate in a dividend reinvestment program or you might have a given percentage of your paycheck withheld to buy an index fund through a 401(k) plan. The systematic approach is often coupled with a rules-based system for which securities are purchased; e.g,. with an S&P 500 index fund, you outsource the decision to the committee of individual men and women responsible for determining the methodology who are, indirectly, outsourcing that decision further to the valuation and market timing groups as they are the one setting the price under the present construction.
- Market Timing: You buy or sell based on what you think the stock market is going to do in the future; e.g., selling when you think stocks are due for a crash or buying when you think the market is going to appreciate for one reason or another.
With few exceptions, that’s it. Whether you realize it or not, you’ve chosen a path. Sometimes, people are simultaneously engaging in all three in a single family’s investment holdings. More often, they stick to one core approach (e.g., systematic purchase of index funds) and add a secondary augment (e.g., picking a few individual dividend stocks in great firms during stock market crashes). Let’s take a closer look at each philosophy.
1. Acquiring Ownership with a Valuation Approach
The first approach is most often favored by experienced business owners, value investors, insiders, and executives. It requires an understanding of accounting, finance, (in some cases) economics, relevant regulations, and a host of other factors that give you an idea of what an enterprise is truly worth. It isn’t unusual for specialists to develop certain areas of knowledge and stick to them, building wealth over decades as they focus on banks or oil, technology or pharmaceuticals. Ultimately, it is the only approach that matters because it is intrinsic value that acts like gravity on the other two, exerting its influence as it is the mean to which all else reverts. The key attractions of this approach, when implemented wisely, are what many value investors believe to be more sustainable returns and risk reduction due to the insistence upon a margin of safety. Although some exceptions exist (e.g,. Benjamin Graham’s net working capital basket approach in the aftermath of the Great Depression), valuation-based investors tend to be long-term focused, practice low turnover, and seek optimal tax efficiency.
2. Acquiring Ownership with a Systematic Purchase Approach
Most people have neither the time, skill, nor inclination to dedicate themselves to that sort of operation. As a result, people like Benjamin Graham and John Bogle came along and suggested a formula-based approach be taken as a next, best alternative. This approach took many of the best attributes of intelligent investing – a long-term focus, low turnover, diversification, reasonable tax efficiency – and apply it to a list of individual stocks and bonds held in a cost-efficient way. Graham came up with a checklist of attributes one should use when constructing a “defensive portfolio” as he called it, while Bogle encouraged people to outsource the work to his firm, which, in turn, outsourced it to the aforementioned committees (though, to be fair, that is only for a handful of index funds; of its $3.1+ trillion in assets under management, Vanguard has $2.15 trillion in passive index funds and almost $1 trillion in actively managed funds, with the active funds outperforming the passive funds for many years now because most of the active funds still adhere to the disciplined Graham-like approach and can take advantage of some of the stupidity in the index construction that has happened since 2003 when the rules began to be quietly changed). Roughly, as long as you were paying less than 1.5% for all services, inclusive (with a few exceptions that can make sense – e.g., a $500,000 trust fund at Vanguard once all is said and done is going to run you 1.57%, which still a very good deal all things considered), you might expect to do reasonably well if you stuck with a program and regularly acquired through bull markets and bear markets, good times and bad times.
Graham, perhaps the original behavioral economist, understood that people in the second category would be tempted to “do something” when they felt the market was unduly high or unduly low so he created parameters stating that bonds should not fall below 25% of a targeted asset allocation or rise above 75% and visa versa for stocks. If things got truly out of hand, the investor could use systematic sales, new deposits, dividends, and interest to slowly rebalance his way to the new, preferred mix, relieving the pressure to act while improving the odds that a significant failure in judgment didn’t throw the investor too far off-course. Bogle has indirectly adopted this approach in his writings, though he refers to the excess valuation multiple applied to earnings as the “speculative” return component, which, in turn, informs his own asset allocation. Different lyrics, same song.
3. Acquiring Ownership with a Market Timing Approach
The market timer, in contrast to all of this, is concerned with what he or she thinks the stock market will do in the short-term future; whether a stock or other security will go up or down. Many apply technical analysis to some degree or another. Many try to exploit their hypotheses with the use of derivatives or borrowed money. Most end up broke or doing poorly over time but a handful, either through luck or skill, do extraordinarily well, fueling the dreams and ambitions of those who would seek to emulate them.
An Example of How All Three Ownership Approaches Might Work
Let’s imagine you’re in an ordinary interest rate and inflation environment and you’re looking at a stake in a large, successful business. This stake, your part of the enterprise, produces $100,000 in after-tax earnings with a reasonable expectation of 12% growth over the next decade, 3% terminal growth thereafter. A reasonable investor might conclude fair value is around $2,200,000.
An investor taking the value approach might pay $2,200,000. If the empire were truly remarkable, perhaps a bit more. Ideally, he or she would want a price of $1,474,000 or less, acquired during a period of market panic like 2009. As long as the underlying earnings projections are still intact, this investor doesn’t care if the market quotation of the ownership stake falls to $900,000 the moment after he or she has bought it. It’s inconsequential as long as they aren’t forced out by a so-called “take under” transaction. Charlie Munger is an excellent illustration of this approach. He values each business in which he takes an ownership stake, famously sitting on Treasury bills for years at a time then swooping in to acquire positions he holds for the rest of his life. During the last collapse, he bought obscene amounts of Wells Fargo & Co. stock for practically nothing, unloading cash reserves with breathtaking rapidity. In 1973-1974, the portfolio under his control was down a staggering 75% on paper but it didn’t matter because he had valued the real on-going business value of each position as if it were a private company he were acquiring to operating himself. This investor would be nervous if the stake rose above $3,500,000, perhaps considering selling for a more attractive opportunity as the price could not be justified.
An investor taking the systematic approach would regularly buy into the ownership stake regardless of whether the price was $900,000 or $3,500,000, figuring it would work itself out in the end. Sometimes, they’d get a great price. Sometimes, they’d get a terrible price. Over a lifetime, it’s a wash; at least, that’s the hope, which may or may not turn out to be the case. (It’s worked out that way, historically, but past performance is no guarantee of future results.) The really smart investors in this category, in my opinion, choose the handful of 50 or 100 great firms – the Colgate-Palmolives, Johnson & Johnsons, and Coca-Colas of the world – and buy them for costs that were next to nothing thanks to a dividend reinvestment program or low-cost brokerage or retirement account. With strong balance sheets, diversified income sources, and economic engines that make their competitive position nearly non-assailable, even when bought at stupidly high valuations, they tend to burn off any excess valuation over 20, 25+ year periods and still compound at satisfactory rates despite a few bankruptcies in their midst, such as Eastman Kodak. Again, there is no guarantee that will continue to be the case in the future but I’m trying to explain the reason people take this approach and the general thought process behind it.
An investor taking the third approach – who isn’t really an investor at all, in my opinion – might look at the price at any given moment and say, “I think stocks are going to fall, therefore, I’m going to sell with the hope of buying back at some point in the future” or “I think this stock is going to skyrocket, therefore I’m going to buy it”. At first glance, to the inexperienced, this may look like it has hints or echoes of the first approach; valuation. Nothing could be further from the truth. (I see inexperienced investors mix up the two all the time.) The valuation-based investor knows you cannot predict the market. He or she doesn’t try. It’s a fool’s game. Instead, he or she is acquiring cash flows and exploiting the market price to that end, figuring it will work out at some point but not in any way attempting to bank on it because if they are wrong, they’ll eventually get their intrinsic value extraction either through buybacks, dividends, or a buyout. They don’t know when it will happen.
How Each Investor Might Behave When Stock Prices Are High
Now, to the heart of your question: How to behave when stock prices are high. Let’s go in reverse order this time.
The market timer is likely to sell for no reason other than he or she expects stock prices to fall.
The systematic purchaser is going to stick with the systematic purchase schedule he or she established, plugging away until retirement.
The valuation based investor makes case-by-case, security-by-security decisions. It’s all about owning the most risk-adjusted net present value of future cash flows. That’s it. On the purchasing front, he might have to look around harder for opportunities. There are somewhere north of 30,000 publicly traded businesses in the world so there’s nearly always something intelligent to do. If something can’t be found, the cash reserves grow. He’ll never not buy a good deal, or more ownership of a wonderful firm, because stocks are high and might fall tomorrow if the individual acquisition makes sense on its own. He’s totally stock market agnostic. As for selling, again, it requires a security-by-security analysis of deferred tax liabilities and the amount of cash that would be freed up to acquire other net present value earnings elsewhere. If you have a position you bought 25 years ago and it grew at an average of 10% per annum, turning $100,000 into roughly $1,083,500, you have to decide how much of that $983,500 unrealized gain is really an interest-free loan from the government based on your own tax bracket and asset holding method. Does a 30% overvaluation really matter so much in the long-run if it’s a great business and selling it might cause you to give up $300,000 in capital to various levels of government taxation? Especially if you can pass it on tax-free to your children and grandchildren using the stepped up basis loophole? Not really. It’s a different question entirely if the shares are held in a tax shelter such as a Rollover IRA.
For me, personally: I don’t believe in market timing. I don’t think it can be done in any reasonably consistent way. I think most people who try are fools. I believe the academic evidence is crystal clear in support of this. I’ve seen many, many, many, many, many fortunes built by valuation and systematic approaches. I’ve been treated very well in my own lifetime by the valuation approach. I think the key is intelligently-acquired, mostly passive, long-term, tax-efficient holding. It’s so perfectly obvious, I don’t understand why some people allow their emotions to get the better of them.
Every time I pull the spreadsheets used to monitor our holdings, I look at what we own and think of them just like I do the private businesses or a piece of real estate. I try to figure out how much net present cash flow we should collect under most reasonable economic projections. I look around and see if there is a much more attractive opportunity somewhere else. Sometimes, I make adjustments for the purposes of risk management. I’m looking at the net present value compared to the market price, in light of interest rates and inflation. It’s like an engineer standing back from a set of plans and saying, “This is well constructed. Everything is within reasonable parameters. I’m comfortable with it.”
“I don’t spend a lot of time thinking about the stock market proper. I’m more concerned with the specific earnings of a specific firm relative to a specific price I paid or want to pay.”Most of my time is figuring out 1. what I want to buy, and 2. the price at which I want to buy it. I’m fine holding cash, if necessary. Most of the selling I do is about risk mitigation. I’m of the school, “Well bought is well sold”.
I wish I could be more “here are some easy rules to follow” but it’s such a unique, situation-specific thing. It’s like cooking, when you need to tweak the seasoning. Or rearranging the furniture in a room. I do the intellectual side of it – the cold numbers – then I tweak the edges until it feels right and I can sleep at night without any worries, even if the stock market were to close for 5 years. I view each position we own as a stand-alone opportunity then analyze how it falls within the overall portfolio. I don’t spend a lot of time thinking about the stock market proper. I’m more concerned with the specific earnings of a specific firm relative to a specific price I paid or want to pay.
I will say that for those who are inexperienced and stick largely to the formula approach, I think it’s a mistake to begin deviating from the plan you’ve put in place if you’re talking about time periods of more than 10 years unless we’ve totally jumped the shark – something like earnings yields on the S&P 500 at 1/2 or 1/3rd the yield of a 30-year Treasury. That seems to happen only a couple times a century, thankfully. I say this because I’ve witnessed too many people who have no idea what they are doing start market timing, deluding themselves they are somehow acting on valuation. They sell some stakes in wonderful businesses because prices are high, but if you actually ask them, “What are the cash flows you expect in the next decade? What was your discount rate? What is the implied real rate of return you expect or demand – is it more or less than the historical 6.5% real (net of inflation) return demand from equities that investors have traditionally required and if so, why? What were your assumptions about taxes and costs? How long could you remain parked in cash at zero percent rates of return before you lost ground to your former overvalued position?” they have no idea. They were simply betting the stock price was going to decline and justifying their desire to act with some general, vague sentiment that felt logical enough for them to waive it off with their hand. This tendency in the inexperienced is so bad that Morningstar Investor Return figures (what investors actually made as they put money into their holdings versus the underlying compounding rates of those holdings) are atrocious. One of the latest data sets I saw covered the 10-year period ended December 2013. The typical mutual fund during that time provided total return of 7.3% but the actual mutual fund investors made only 4.8% because they kept moving money in and out trying to predict the future or chase returns. It’s such a waste both for the investor and for the fund managers, who have to deal with the added costs caused by the folly.
Read More: On January 20th, 2016, I wrote an update and expanded essay on this topic called Market Timing, Valuation, and Systematic Purchases.
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