The S&P 500’s recent rally may cause some investors to become overly optimistic about the stock market’s prospects. This could be a dangerous situation, in my view, as a result of the uncertain outlook for the economy.
Therefore, following the advice of Peter Lynch could be a good idea. His patient approach and focus on fully understanding business models in a changing economy may be key reasons for his long-term outperformance of the stock market.
A patient strategy
The recent rise in stock prices means that some investors may fear missing out on further gains. This may lead them to invest in overvalued stocks that have risen in the past couple of months, or in businesses that do not have favorable financial outlooks as a result of economic uncertainty.
A better idea could be to wait for more attractive valuations before buying stocks. This may mean that you are able to purchase quality companies when they offer wider margins of safety. This may reduce your risks, as well as provide greater scope for long-term capital growth.
Low interest rates currently equate to minimal returns on cash savings. However, holding some cash may be worthwhile if more attractive stock valuations will soon be accessible. As Lynch once said, “If you can't find any companies that you think are attractive, put your money in the bank until you discover some.”
Understanding your holdings
A rising stock market can cause some investors to underestimate the importance of fully researching companies before buying them. For instance, they may feel that understanding a business is less important than usual in a rising market where investor sentiment is improving.
However, knowing the strengths and weaknesses of any business that you intend to buy is crucial when assessing its investment prospects. The process of analyzing a company allows you to determine its intrinsic value, and therefore whether it offers a margin of safety at its current price level. Thorough analysis also means that you can find out whether a firm has a strong financial position through which to survive an uncertain outlook for the economy.
Seeking to understand your potential holdings is likely to be a productive use of your time. It could allow you to allocate your capital more efficiently, and to avoid overpaying for low-quality companies. As Lynch once said, “The worst thing you can do is invest in companies you know nothing about. Unfortunately, buying stocks on ignorance is still a popular American pastime.”
Earnings forecasts
It is tempting to be overly optimistic when assessing a company’s financial outlook in a rising market. For example, at the moment there are a number of highly-valued technology companies that have very bullish earnings forecasts.
Those estimates may prove to be correct. However, it is impossible to accurately predict how a company will perform in future. Highly-valued companies that disappoint high expectations on their earnings performance versus estimates could be severely punished by investors, and may record substantial falls in their stock prices.
Therefore, it is important to avoid becoming overly exuberant about a firm’s profit outlook. Eventually, the stock market is likely to demand that higher earnings are delivered to merit a rich valuation.
Lynch previously discussed his focus on company earnings, and their importance in determining a stock’s price level: “If you can follow only one bit of data, follow the earnings -- assuming the company in question has earnings. I subscribe to the crusty notion that sooner or later earnings make or break an investment in equities. What the stock price does today, tomorrow, or next week is only a distraction.”
Read more here:
- Charlie Munger on Valuing Stocks
- Seth Klarman on Why Value Investing Is More Important Now Than Ever
- Howard Marks on the Importance of Self-Discipline
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