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Can You Be 100% in Stocks Even When the Market Is Overvalued?

Geoff Gannon

Geoff Gannon

409 followers
Someone who reads my articles sent me this question:

Hi Geoff,

In your own personal portfolio, do you attempt to be invested 100% of the time?

Does your opinion change looking back at the last 10 years?

Looking forward would you attempt to be 100% invested?

Regards,

Steve

This is actually a topic I’m wrestling with for something we’re developing here at GuruFocus.

A lot of people think you shouldn’t be 100% in stocks. Now, if by stocks we mean index funds, mutual funds, etc. – I agree. I would very rarely be 100% invested in stocks if I was delegating stock picking to someone else. But, as you know, I don’t invest in funds. I pick my own stocks. And I tend to pick very few of them.

If you are a concentrated investor who owns just a few stocks and those stocks seem set to deliver adequate returns – go ahead and keep them no matter how expensive the market gets.

I mentioned a few stocks I bought back around 2000 (they were bought over a span of almost three years). Those stocks were:

· J&J Snack Foods (JJSF)

· Village Supermarket (VLGEA)

· Activision (ATVI)

Let’s use one of those as an example of how owning a stock and owning the stock market can differ. Over the last 10 years, the S&P 500 has returned about 4% a year.

Meanwhile, J&J Snack Foods has returned about 11.4% a year. For much of that time, J&J Snack Foods traded at acceptable prices. The price-to-book ratio ranged from 1.8 to 2.9. The company’s average return on assets is about 9%. It doesn’t use leverage. So, the ROE isn’t much better than the ROE. But a normal return on equity for JJSF should still be in the 10% to 12% range. At the highest year in terms of average price-to-book ratio (2006 – 2.9x) and the lowest return on equity assumption (10%) we are talking about a 3.45% return on the stock’s then current price. You could consider selling at that point. At about 3 times book value, no matter how much you like JJSF as a business it is unlikely to produce returns that are much better than you could get by selling your shares, parking the proceeds in cash, and waiting for a better time to buy stocks (than 2006). When returns are that low, you can sell your stocks, hold cash – and wait for better prices.

But, in all the other years from 2000 to 2012, I don’t think you needed to pay attention to the overall level of the stock market if you owned J&J Snack Foods. I think if you liked the management, you liked the company, etc., and the stock was trading at 2.3 times book value or less (as it did in every year other than 2006) then it would be fine to take your roughly 5.2% return (as I calculate it – 12% normal ROE/2.3x book value) in a food company that’s not using leverage. I think earning 5.2% a year in a business you like run by a manager you like without any debt is an acceptable option. It’s not the world’s greatest return. So, if you had a better stock idea – by all means, sell JJSF and buy that stock instead.

But should you sell out of a situation you know and like that’s still doing more than 5% a year for you just to park the money in cash? To give up an expected 5% a year return, to part with a business you like, to get yourself all worked up about timing the sale of the business – I just don’t know if it’s worth it.

I wouldn’t sell a stock just to have cash. I’ve said this before, but I really don’t sell stocks except to buy other stocks. Now, that doesn’t mean I never end up with cash – I’ve had 50% of my portfolio in cash for a month or two or five at various points in the last few years. But only because I got bought out of something and didn’t have anywhere new to put the cash immediately.

I definitely advise taking it slow in those situations. I do my worst investing when I have a lot of cash. You should do everything you can to take the pressure off deploying cash. If there is nothing smart to do – don’t do anything at all.

I didn’t think stocks were cheap in 2006. I thought they were more expensive than at any time before 1996, and I said so on my blog. I thought return expectations among investors were way too optimistic.

Doesn’t that mean I should sell my stocks and hold at least some cash?

Or maybe bonds? Or some gold? Or…

No. I wouldn’t do that. At a minimum, I think there’s no reason to sell a stock you know, like, and have lived with for awhile unless you have compelling evidence that staying in that stock will return less than choosing an alternative asset class (not stocks).

If you look at investments other than stocks – unless you buy them at what you know is a discount to their historical average prices – it’s not reasonable to assume better than 6% nominal returns. If you had just owned bonds continuously, or oil continuously, or gold continuously for years and years you didn’t make more than 6%. And you often made less.

I’m not saying you can’t time those things. It may be possible to buy other assets – like bonds – when they are nice and cheap. That’s fine. But when you sell out of stocks because you think the market is too high – you shouldn’t assume you can find things outside of stocks that will return 6% or better. In fact, you should expect less.

Stocks have historically outperformed other assets. And at many different starting points (even in rather overpriced years) you could’ve made an adequate return in stocks if you held them long enough. When you see illustrations of how much better it would’ve been if you could’ve sold before some big stock market decline or something – these illustrations are often using calculations based on rather silly ideas like putting all of your money into stocks in the late 1920s or 1990s rather than putting in money over time.

I certainly know some people who went from 0% in stocks to 100% in stocks in the late 1990s. But I would hardly call them investors. They got caught up in a mania. They hadn’t been interested in picking stocks before 1996 and they haven’t been interested in picking stocks since 2000.

It’s sad. But that’s not really your problem if you’re paying close attention to stocks – trying to improve your investing – over a lifetime. For people like that, the issue of buying at the exact wrong time is not as much of a concern – because you’re going to end up buying stocks in a lot of different years over the course of a lifetime.

Unfortunately, lots of people will lose money by buying into a bubble. But I hope that it’s not people reading the articles I write. Because I figure people reading these articles have more than a passing interest in stocks. If you are interested in the market and working to pick stocks over a period of years and years you are unlikely to put a lot of new money into the market at exactly the wrong time (or exactly the right time).

Look, the stock market is not cheap today. You are not going to earn a great return by buying an index fund today. You aren’t going to earn a great return by putting money in a mutual fund.

You might do just as well in higher yielding corporate bonds (government bonds, gold and silver are clearly overpriced). If you don’t care one way or the other if you are invested in stocks or bonds – go ahead and buy something like SPDR Barclays Capital High Yield Bond Fund (JNK). Put half your money in stocks and half in high yield corporate bonds.

Just as an example – and there are lots of combinations like this we could think of – I’d be fine telling someone to divide their money between:

· Hussman Strategic Growth (HSGFX): 33%

· SPDR Barclays Capital High Yield Bond Fund (JNK): 33%

· Berkshire Hathaway (BRK.B): 34%

Not because I think that odd little portfolio would do especially well. But because I think any fairly large group of indiscriminately chosen stocks isn’t going to do much better than that portfolio over the next 10 years.

I have no reason to believe that portfolio would perform worse than the stocks most people reading this article will buy over the next 10 years. I don’t expect the next 10 years to be a wonderful time for stocks. I don’t expect them to be a wonderful time for bonds either.

So, if you’d feel better with a portfolio of junk bonds, hedged stocks and Warren Buffett’s investment company – go for it. I think you’ll end up in about the same place 10 years from today. And if it’s a smoother ride, you’ll be more comfortable – and less likely to pull your money out at the wrong time.

I’d say differently if stocks were undervalued. As a group, stocks are not undervalued. There are, however, plenty of undervalued stocks. And it’s not even necessary to find terrific bargains to earn the kinds of returns investors in stocks have achieved in the very long run.

All you need to do is find above average businesses selling at about the average price for the average business over the last century.

I’ll give a concrete example. Two of them actually. This explains why I think the idea that sometimes even a stock picker has to be out of the market entirely is a silly idea.

Let’s take a look at Carnival (CCL) and Royal Caribbean (RCL). Here’s a rare example of two stocks where Warren Buffett and Ben Graham could both give us their blessing. (Warren much more so with Carnival than Royal Caribbean – but that’s an article for another day). Carnival and Royal Caribbean both trade at 13 times their 10-year average earnings per share. That’s a fair price for a stock. In fact, 13 times the average earnings of the last decade has been a fair price for stocks throughout much of stock market history.

Together, Carnival and Royal Caribbean account for about 78% of the worldwide cruise market. Barriers to entry are as high in the cruise industry as any industry you’ll find. Returns on assets are far from spectacular. Expect railroad like numbers. Carnival can earn 7% on assets and use up to 2 times leverage. Royal Caribbean’s competitive position is dodgier. But both companies can earn around 10% on equity if they compete with each other – and place orders for new ships – in a rational way. That is one of the big questions here.

If I do a back of the envelope type calculation, I figure that Carnival and Royal Caribbean shares bought at today’s prices can deliver about 10% a year over the next 10 years.

Now, I’m not saying you have to rush out and buy shares of CCL and RCL. I’m not even saying I know they’ll be terrific investments over the next year or two. I’m not even saying they are the right investments to make. After all, I only said I think their shares can return about 10% a year over the next decade, if you buy them today. Maybe you know of other ideas with much higher returns. That’s fine.

What I am saying is that CCL and RCL are both huge businesses. They are both liquid stocks. They have annual reports on their websites going back at least a decade each. You can find information on EDGAR for CCL that actually goes as far back as the 1993 fiscal year. The industry is extremely well documented. There have been a couple books written about the industry. Devils on the Deep Blue Sea and Selling the Sea are good examples. CNBC did a little hour long special (focusing on Norwegian Cruise Lines). It’s a “Watch Instantly” title on Netflix. And if you’ve never been on one of these companies’ ships – you probably know someone who has. So the scuttlebutt part of things will not be difficult. This is an industry you can understand.

Both CCL and RCL talk about how many new ships they’ve contracted for. So supply growth – from the biggest players – is a lot easier to keep track of than in industries where competitors come and go.

My point is not to make this into an article about CCL and RCL. It’s that say you did your research – we know there’s enough information out there – and you liked what you saw. All you need to do is prove the next 10 years will be reasonably similar to the last 10 to 20 years for these two companies. If their futures are within spitting distance of their pasts, this is some place you can make high single digit to low double digit returns a year over the next ten years.

High single digits to low double digits is all you can expect in a diversified basket of stocks even in a fairly valued or slightly undervalued market. So, by finding such opportunities today you’re essentially finding the same kinds of returns investors get in “normal” times.

You don’t need to make any aggressive assumptions or time when you buy and sell the stocks. If their business performance is fine over the next 10 years, the stock prices will follow. It may not even be necessary to pick a single stock. You can buy about three-quarters of the cruise business by splitting your investment between these two stocks.

Now, I’m not yet sure if CCL and RCL are actually stocks I would buy right now. But, I am sure that when you compare these two stocks to the alternatives – outside of the stock market – where I can park my money, they look attractive.

And that’s my problem with the whole argument that sometimes you should be out of the market. Or sometimes you should have less than 100% of your money invested in stocks.

Absolutely. If you don’t have enough good ideas – you shouldn’t be 100% invested in stocks.

But if I find a business situation I think I can understand where I can make 10% a year, I’m not going to do nothing just because the Shiller P/E is 23 right now. The Shiller P/E has been about 23 or higher for most of my investing life.

That doesn’t bode well for stocks. The S&P 500 is not going to return 10% a year over the next 10 years. But CCL and RCL might. And it’s a stock picker’s job to find situations like that. And you only need a few.

So I would never make a top down decision to be less than 100% invested in stocks just because I know stocks are overvalued. If I can find undervalued stocks, I’ll buy them. Even if it’s 1999 or 2000 and I know the S&P 500 is in a bubble – it doesn’t matter. There are stocks that have done fine from 2000 through today. There were stocks in 2000 trading at perfectly normal levels. There are stocks today trading at perfectly normal levels.

You certainly can’t say the prices of CCL and RCL are too high. Maybe their prices – like the price of Best Buy (BBY) – accurately reflects a very dim future. The prices could be right. But they can only be right because the businesses are poor, unsafe, etc. It’s not because those stocks are overvalued even if the S&P 500 is overvalued (which it is).

When you broaden your stock selection beyond multibillion dollar behemoths like CCL and RCL to include smaller companies like CEC Entertainment (CEC) and Ingles Markets (IMKTA) and Ark Restaurants (ARKR) or you look at railroads like Norfolk Southern (NSC) or utilities like the four I mentioned that passed a Ben Graham screen (all four of which have dividend yields of around 4% or higher) you see that you don’t necessarily have to earn the same returns the S&P 500 is going to earn over the next 10 years.

The companies I mentioned don’t have the kinds of price to average earnings the S&P 500 does. They seem to be selling for a much lower ratio of their normal earnings. And they have a history of either growing their earnings over time – or paying almost all of those earnings out as dividends (or share buybacks).

If you can sort through a list like this one:

1. Carnival (CCL)

2. Royal Caribbean (RCL)

3. CEC Entertainment (CEC)

4. Ingles Markets (IMKTA)

5. Ark Restaurants (ARKR)

6. Norfolk Southern (NSC)

And find one stock where you understand the business, like the management, see a fine future in store – and know you can hold that stock for the next 10 years – you don’t have to bet on the S&P 500 with your stock portfolio.

All you have to do is find one stock like that every once in awhile. No one needs more than 10 stocks. So, if you’re holding stocks for up to 10 years at a time – you don’t need to pick a new one much faster than once or twice a year.

And I haven’t even talked about the possibility of investing in net-nets or in other countries. I have 50% of my portfolio in Japanese net-nets. I don’t look at the Shiller P/E ratio to tell me if now is the right time to sell my Japanese net-nets.

So, for someone who is spending a lot of time picking a select few stocks – there’s no reason not to be 100% invested in stocks as long as you have enough good stock ideas.

Sometimes the stock market is overvalued, but there are still enough good stock ideas to fill a portfolio. When that happens, you should be 100% invested. And when it doesn’t happen, you should have some of your money in cash.

My preference is to be 100% invested in stocks. That’s true today even though I know the stock market is not cheap.

So you should look at your own investing and look at how much stock picking you’re really doing. How different are your returns from the S&P 500? If looking back on your returns you find that your stocks move in lockstep with the S&P 500 – then you shouldn’t be 100% invested in stocks when it’s clear the stock market is not cheap. Because there’s a pretty good chance the stocks you’re picking aren’t cheap either.

But if you tend to pick stocks that do not mirror the S&P 500, then the only question is how good your ideas are.

If your current ideas are as good as ever, you should have as much of your portfolio in stocks as you’ve ever had. If your current ideas aren’t as good as ever, you shouldn’t have as much of your portfolio invested in stocks as you have had in the past.

Right now, I have about 85% of my portfolio in stocks. And I’m okay with that.

Even though I think the stock market is overvalued.

Read Geoff’s Other Articles

Ask Geoff a Question

Check out the Buffett/Munger: Bargain Newsletter

Check out the Ben Graham: Net-Net Newsletter

About the author:

Geoff Gannon
Geoff Gannon


Rating: 4.7/5 (27 votes)

Comments

bmichaud758
Bmichaud758 - 2 years ago
Just out of curiosity, how did your portfolio hold up let's say from late 2007 to late 2009? I think that time period would be a good indication of how one's investment style would hold up when a margin of safety is needed most (I could be more stringent and ask how it performed from late 2007 to March 2009, but that's probably a little unfair).

As all value investors know, Monish Pabrai got crushed during this time frame despite applying a stringent margin of safety requirement to his stock picking, which brought his long-term CAGR down from the mid-20% range to around 15%. I only use him as an example because he is probably the best example of how to pick small cap "inefficient" stocks for the individual investor seeking to adhere to Buffett's "if I had $50 million I could return 50% per year" thesis.

So what if you miss out on some gains by holding cash in over valued markets? Not only do you strongly outperform the market on the way down by being "fearful when others are greedy" in the form holding cash, you have capital available to deploy into outrageously cheap assets that others are dumping due to fear.

Many would label this as "market timing" - absolutely false. Very simply, it's an exercise in market valuation - i.e. buying when others are fearful and selling when others are greedy. There is zero timing involved. So what if you went to 50% cash in late 2005? As individual stock pickers, our stock picks should be good enough to over come this cash drag (as demonstrated beautifully by Bill Ackman who held on average 30% cash while returning 30% net of fees per annum while investing in BIG CAP STOCKS leading up to the 2007 top before losing only 12% in 2008) while keeping cash available to deploy in times of distress.

There's a reason Buffett intentionally deployed capital into "workouts" back in the 1960's EVEN WHILE he was able to find attractive individual opportunities such as AMEX, Sanborn etc.. etc...He clearly stated in his letters that he had a rough allocation procedure between General and workouts/private situations based on the general level of the market. Going even further - when he completely exited the money management business in 1969/1970, can we honestly say Buffett wasn't able to find ANYTHING to invest a paltry $150MM into in a massive US equity market? There had to have been SOMETHING. IMO, there was something to invest in at the time, but Buffett was too worried about the general market. The Schiller PE back then was only slightly greater than it is now AND it took several years for the market to actually correct to a point where Buffett declared that he was like an oversexed guy in a harem.

All that to say, I would argue NOT holding cash in a generally overvalued market is more foolish than missing out individual opportunities for two reasons: 1) a decently diversified equity portfolio will inevitably go down in sympathy with a general market correction, and 2) even a big year of 100% gains is wiped out entirely by a -50% decline. Over time, as Buffett has demonstrated throughout his entire career, losing less in a decline, though relative at the time, pays off absolutely over time.

Given the general market valuations currently in place, the risk to profit margins as fiscal deficits inevitably contract, and the likelihood that developed countries' deleveraging will keep all types of growth very subdued for an extended period of time, I would pose the following three-year bet using a basket of BAC, SD, AIG, BRK, DELL, XRX, MSFT, CHK, S, BBY (all popular "value" investments right now):

Portfolio A: must remain 100% invested in all 10 securities for the duration of the bet (i.e. 10% positions at initiation)

Portfolio B: must hold 60% cash when the Schiller PE (using median earnings, NOT average, so to take out the ultra-low years of 2008/2009) is >= 20, 40% cash when it's 18-20, 20% cash when it's 16-18, and 0% cash when its less than 16. All ten securities must be held in whatever equally-weighted proportion the equity portion will allow.

Regardless of how high the expected return is for this portfolio, I'll take Portfolio B any day of the week - my guess is that the performance relative to Portfolio A let alone the general market is going to be significantly higher over the three years.

batbeer2
Batbeer2 premium member - 2 years ago
>> As all value investors know, Monish Pabrai got crushed during this time frame despite applying a stringent margin of safety requirement to his stock picking, which brought his long-term CAGR down from the mid-20% range to around 15%.

Seth Klarman also applies "a stringent margin of safety requirement".

Both gentlemen:

1) Manage other peoples money.

2) Take large positions in relatively illiquid stocks.

Of course, this is a lethal combination if your clients have a herd mentality.

It's not the strategy that caused Pabrai problems. It's the clientele.
superguru
Superguru - 2 years ago
"when the Schiller PE (using median earnings, NOT average, so to take out the ultra-low years of 2008/2009)" - Bmichaud758

Does multpl.com use median or average earning? Any site which gives Schiller PE using median earnings?

sjzhao2003
Sjzhao2003 - 2 years ago
Frankly, I don't see the relevance of market valuation to your or my own investment decision. All that matters is the valuation of each security you're buying relative to their intrinsic value: does it offer a big enough margin of safety or pass a high enough hurdle rate. What often gets people (I can definitely relate to this) into trouble is when the market is expensive, they start to fudge with their hurdle rate and end up buying things they wouldn't buy in a less expensive market. That's the problem. It's not the overall valuation of the market, rather it's what people do IN RESPONSE to that valuation.

Successful investors have very high hurdle rate and stick to it in the face of expensive market whereas less successful ones are more flexible with their hurdle rate.

bbsannidhi
Bbsannidhi premium member - 2 years ago
great article for todays market conditions.
Adib Motiwala
Adib Motiwala - 2 years ago
GG,

1. Carnival (CCL)

Cash flow from Ops $3.3b, $3.8b, $3.8b (2009 - 2011)

Capex $3.4b, $3.6b, $2.7b (09-11)

FCF 100m, 200m, 1100m

Does this not concern you?

if that was not enough, check the balance sheet : $9b in debt

Market Cap $26billion.

Honestly, I dont think either WB or Ben Graham would be interested :)

2. RCL is worse than CCL. $8b in LT Debt for a $6b market cap and no FCF. All cash flow goes to capex.

5. ARKR is interesting.

InvestingOnSale
InvestingOnSale - 2 years ago
"If I was running $1 million today, or $10 million for that matter, I'd be fully invested."

-Buffett to BusinessWeek in 1999

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