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Stock Market Valuation: Caution Warranted
Posted by: Jason Fieber (IP Logged)
Date: July 19, 2013 07:28AM

I wrote an article a little while back explaining why I don't value the entire stock market, but rather individual companies. As an investor who buys shares in individual, high quality companies the valuation of the entire market is but a secondary concern. However, that doesn't mean that I completely ignore the valuation of the market or abstain from even paying attention. Rather, I do pay attention to overall valuations if only because I look at it like a check on the "weather". Is it sunny and warm outside, or are storm clouds brewing on the horizon?

When I wrote the above article, the Shiller P/E ratio was at 21.70. The mean value is 16.47, going back before 1900. The Shiller P/E is now at 24.64. You can see that below:

Shiller PE

Now, I'm not some doomsayer that is predicting a calamity in the market. Moreover, I'm continuing to invest fresh capital every single month into high quality companies that have a history of raising dividends just like I have been for the last 3+ years. However, that doesn't mean I'm not anxiously watching the valuation of individual companies. I'm extremely cautious about which companies deserve my hard earned cash, and I believe it would be prudent to continue this cautious outlook as long as broader market levels stay this elevated. The list of suitable investments where I feel comfortable putting money to work is becoming smaller and smaller as the months wear on.

Many high quality companies are trading at valuations right now that may lead to slightly disappointing total returns over the short-term. That's not to say that many of these companies won't make fine investments when you're looking out 20 or more years, but if I can buy high quality merchandise for sale prices I'm all in.

For instance, The Coca-Cola Company (KO) is currently trading for a P/E ratio (using TTM earnings) of21.4. The 5-year average is 17.6. Certainly I'm all for paying up for quality, as I believe there is nothing wrong with paying a fair price for a high quality company (I've done it on many occasions). And depending on the valuation model, I could agree that KO is trading for fair value today. However, if investors average in to Coca-Cola shares at a level for almost 20% less than they're currently trading for is it prudent to buy today? That's a question only an individual investor can answer.

The above quandary is present for many high quality companies today. Companies like Johnson & Johnson (JNJ), PepsiCo Inc. (PEP) and Philip Morris International (PM) all appear to be trading shares for levels higher than what investors have been willing to pay in the past. Certainly, as I've pointed out many times before, it's tough to build a portfolio, and a rising stream of passive income via dividends, if you're not actively buying ownership stakes in wonderful businesses. However, what I believe to be prudent today is to really think hard before you invest your capital, and strive for value when it can be found.

I believe value, or what little of it is there, can currently be found in sectors that have not run up as much as the broader S&P 500. One could look at high quality companies in the Basic Materials, Real Estate and Energy sectors for better values than what might be found in Consumer Cyclical, Consumer Defensive and the Healthcare sectors. That's not to say that there aren't deals to be found in the latter list, but rather that the former list might hold better opportunities for the enterprising investor.

What I'm going to change is this: nothing. I believe in persistence and I continue to stay steadfast in my approach to building wealth. I scan for the best opportunities I can and strike when capital and allocation allows. For example, a couple of my most recent purchases were shares in Royal Dutch Shell plc (RDS.B)and Digital Realty Trust, Inc. (DLR). Both are high quality companies that are in the sectors that I listed above that have not done as well as the broader market. Both companies have severely underperformed the broader market by a wide margin YTD. As always, I put my money where my mouth is.

I'm actually hoping for a broader market pullback over the next couple months, which would surely bring down the prices on some of the high quality companies I'm currently invested and also those that I long to own a piece of. While this would mean that the paper value of my investments are less, and my net worth is then lower, it would also mean that my new capital goes further by buying larger stakes in the companies I'm actively purchasing. Those larger stakes means more shares for the same amount of money, and more shares means more dividends. More dividends gives me more ammo with which to further increase my ownership stakes in these high quality companies. A wonderful cycle. Just like I enjoy a good sale at the grocery store on new food that I need to buy to eat today, I enjoy cheaper shares on high quality businesses that I'm looking to buy today so that I can build more wealth tomorrow.

How about you? Do you believe caution is currently warranted?

Full Disclosure: Long KO, JNJ, PEP, PM, RDS.B, DLR

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Re Stock Market Valuation Caution Warranted
Posted by: SeaBud (IP Logged)
Date: July 19, 2013 10:17AM

Agree fully. Sold my JNJ at around $85 as I didn't see growth justifying a p/e of 21. Of course it is now around $90. Have bought RD Shell, Volkswagen and GE and feel good about their dividends and valuations. Tech stocks also offer some nice dividends but you must deal with the volatile underlying business.

I would guess there will be a broader market pullback where these highly valued companies will be hurt more than the lower multiple companies, or if the economy picks up steam, people will lose some fear and get out of these "safe" stocks. In any event, it is hard for me to justify 20x+ p/e for slow growing, huge consumer product companies when other safe businesses with lower multiples and similar dividends are out there.

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