The S&P 500 has gained 45% since it reached a three-year low in March 2020. Therefore, it is currently in a bull market, despite the economic recession.
Historically, investors have become increasingly optimistic about company earnings and growth prospects in bull markets. Therefore, valuations can become excessive.
In my view, it could be a good idea for investors to follow the advice of Benjamin Graham given current market conditions. The father of value investing’s focus on company valuations and business fundamentals could be key reasons for his ability to apportion capital efficiently in a bull market.
Excessive valuations
Investor expectations about the growth prospects for a range of companies have increased in the past few months. This has caused the valuations of some stocks to rise to extremely high levels.
Even if richly-valued companies can deliver on their optimistic growth forecasts, investors may not necessarily generate high capital returns from buying them today. Their current valuations may already take into account improving financial outlooks, with them offering little or no margins of safety for new investors.
Therefore, it may be a better idea to apportion capital across companies that offer good value for the money based on their financial prospects and stock prices. Otherwise, you may end up holding companies that perform well from a business perspective, but offer disappointing investment returns.
As Graham once said, “Obvious prospects for physical growth in a business do not translate into obvious profits for investors.”
A level-headed approach
Investor sentiment can rise to excessive levels in a bull market. This can lead to investors overpaying for stocks, since they may feel that recent growth trends will continue uninterrupted.
However, the past performance of the stock market shows that permanent bull markets have never occurred. Therefore, investors must prepare for an eventual bear market, when valuations may more accurately reflect business fundamentals.
At the moment, some investors are becoming excited about the growth prospects for many large-cap technology companies. However, the uncertain economic outlook means that their valuations may not fully account for the risks they face.
In my view, maintaining a level-headed approach and taking account of risk when valuing stocks is extremely important in bull markets and bear markets alike. This may mean you miss out on short-term gains for the stock market, but can also lead to you avoiding overvalued stocks that lack long-term investment appeal.
As Graham once said, “While enthusiasm may be necessary for great accomplishments elsewhere, on Wall Street it almost invariably leads to disaster.”
Company fundamentals
Rising stock prices in bull markets can cause investors to overlook the investing basics. For instance, they may become more interested in analyst forecasts for a company than its business fundamentals.
Failing to thoroughly analyze factors such as a firm’s financial position, business model and competitive threats can lead to your capital being allocated inefficiently. A better idea is to approach investing in a bull market with the exact same strategy that you would use in a bear market. Namely, you take into account the risks and potential problems that may hurt a company’s financial outlook instead of solely concentrating on its growth catalysts.
Focusing on company fundamentals may not be as exciting as trying to speculate on how a company’s stock price will perform in future. However, it is a far more robust means of managing your portfolio, and can help you to be better prepared for when the current bull market comes to an end.
Graham consistently operated with the mindset of a businessperson throughout his career, and concentrated his efforts on assessing company fundamentals. As he once said, “Investment is most intelligent when it is most business-like.”
Read more here:
- Peter Lynch on the Dangers of Rising Investor Optimism
- Charlie Munger on Valuing Stocks
- Seth Klarman on Why Value Investing Is More Important Now Than Ever
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