Finding good value stocks to buy has become much more difficult over the past few months. Valuations across the U.S. stock markets have risen and margins of safety have narrowed as investor optimism has surged higher, despite a challenging economic outlook that could hurt the financial performances of many richly-valued businesses.
Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) CEO Warren Buffett (Trades, Portfolio) has a sound track record of investing in similar market conditions. His long-term focus and capacity to invest in the strongest businesses within a specific sector could be key reasons for Berkshire’s 20% annualized return since 1965.
Patient investing
The stock market’s rapid recent rise and the economy’s uncertain prospects may cause some investors to adopt a short-term outlook. For instance, they may seek to make a quick profit based on the assumption that recent upward trends will continue. Or, they could be fearful about the prospect of a market crash and hold stocks for a limited amount of time.
It is impossible to predict the stock market’s next move. There are a wide range of variables that could move its price level higher or lower over any time period. Therefore, using a patient, long-term approach could lead to a more efficient allocation of capital.
This means investing in quality businesses when they offer margins of safety and holding them for the long run. This strategy may help you to avoid trying to time the market, which could lead to high commission costs and disappointing returns. As Buffett once said, “The stock market is designed to transfer money from the active to the patient.”
Dominant businesses
Many companies may face challenging trading conditions in the short run. For instance, changing consumer trends may force firms to quickly adapt their business models. Likewise, the potential for continued containment measures could hurt their financial performances.
Therefore, it may be prudent to buy the strongest and most dominant businesses within a specific sector. They may be able to cope with difficult trading conditions better than their sector peers. They could also use a period of weak trading conditions to their advantage, in terms of expanding their market share.
Even though investor sentiment has improved significantly in this bull market, the threat of a bear market is omnipresent. Therefore, allocating your capital to companies that have strong market positions with wide economic moats could be a means of reducing risks. As Buffett once said, “Buy companies with strong histories of profitability and with a dominant business franchise.”
Value investing
It is tempting to overlook the rising valuations that have come into existence in the current bull market. For instance, investors may determine that a company’s stock price is good value for money relative to other businesses operating in the same sector. However, if those comparative businesses are overvalued, the company in question may also be trading on an excessive valuation.
Likewise, investors may accept paying a high price for a company that is delivering impressive earnings growth relative to its industry peers.
However, in my opinion, it is important to obtain a wide margin of safety in bull markets, just as it is in bear markets. Otherwise, even a company’s strong financial performance may fail to deliver attractive capital returns.
Buffett is known to demand a fair price for even the best quality businesses that are available. As he once said, “For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments.”
Disclosure: The author has no position in any stocks mentioned.
Read more here:
- Howard Marks on Dangerous Valuations in a Bull Market
- Benjamin Graham on Investing in a Bull Market
- Peter Lynch on the Dangers of Rising Investor Optimism
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