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Robert Stephens, CFA
Robert Stephens, CFA
Articles (396) 

Howard Marks on Dangerous Valuations in a Bull Market

Ignoring other investors could enhance your returns

August 04, 2020 | About:

The current bull market may have only lasted for around four months, but many S&P 500 stocks now have extremely high valuations.

Therefore, investors buying stocks today may end up overpaying for companies that face uncertain trading conditions caused by a weak economic outlook.

In my view, following the advice of Oaktree Capital co-founder Howard Marks (Trades, Portfolio) could be a good idea. His willingness to go against the views of his peers and focus on company valuations may produce relatively high returns in the long run.

Overpaying for stocks

The recent updates from a number of large-cap stocks, such as Facebook (NASDAQ:FB) and Amazon (NASDAQ:AMZN), have shown that they are performing relatively well despite a challenging economic environment. This is contributing to them having rich valuations relative to other stocks.

Investors may feel that a strategy of buying companies with strong earnings growth will lead to high capital gains. However, failing to consider their valuations may mean that your investment returns are limited. Other investors may have already factored in their impressive financial prospects via high current valuations.

In my view, paying a fair price for a stock is just as important as selecting a sound business. It is difficult to generate impressive investment returns without obtaining a margin of safety that provides scope for capital growth in the long run.

As Marks once said, “Investment success doesn’t come from buying good things, but rather from buying things well.”

Disagreeing with your peers

The recent rise in stock prices has caused many investors to become bullish about the market’s prospects. This is a common occurrence in bull markets, where investors may become concerned about missing out on further stock price gains. This can cause them to ignore the risks facing companies, and instead focus on the potential for further price rises.

However, even companies that have reported solid earnings figures in recent months face significant risks. For example, the upcoming election or other unpredictable factors could cause investor sentiment to change.

Therefore, investors who have concerns about company valuations should not be afraid to avoid buying overpriced stocks. This may not be a common viewpoint at the moment, and it may not be a profitable strategy in the short run if the stock market continues to rise. However, going against the views of other investors could be a means of avoiding overpaying for stocks. It may also allow you to buy the same companies at lower prices further down the line.

As Marks once said, “Being too far ahead of your time is indistinguishable from being wrong.”

Ignoring recent trends

Investors may be tempted to buy stocks today because they feel that recent growth trends will continue. For instance, they may feel that further monetary policy stimulus is likely, which may help to push asset prices higher.

However, no bull market has lasted forever. Eventually, investors demand that optimistic forecasts are met with tangible earnings growth. Therefore, assuming that recent trends will continue uninterrupted could lead to disappointing returns.

A better idea may be to invest in undervalued stocks for the long term. They could offer less risk and greater return prospects than overpriced companies that require increasing investor optimism to deliver capital growth.

As Marks once said, “Selling for more than your asset’s worth. Everyone hopes a buyer will come along who’s willing to overpay for what they have for sale. But certainly the hoped-for arrival of this sucker can’t be counted on. Unlike having an underpriced asset move to its fair value, expecting appreciation on the part of a fairly priced or overpriced asset requires irrationality on the part of buyers that absolutely cannot be considered dependable.”

Disclosure: The author has no position in any stocks mentioned.

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