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

Howard Marks: Approach Bull Markets With Caution

A prudent strategy may be useful due to rich stock valuations

September 08, 2020 | About:

The stock market has gained over 50% since reaching its three-year low in March 2020. However, the prospects for the economy continue to be uncertain.

Therefore, in my view, a cautious approach to investing in today's bull market could help to efficiently apportion your capital.

Oaktree Capital co-founder Howard Marks (Trades, Portfolio) has previously sought to circumvent over-optimism in bull markets. His avoidance of richly-valued stocks and respect for the economic cycle could be key to his long-term investment success.

Avoiding popular stocks

The current bull market has largely been driven by the increasing popularity of large-cap technology companies. For instance, Apple (NASDAQ:AAPL) has become the first $2 trillion company in history, while many of its sector peers have also delivered exceptional stock price growth over recent months.

It is becoming increasingly difficult to justify their high valuations. Even though they are producing growing profitability in many cases, have solid balance sheets and enviable market positions, investor sentiment has reached a level that already factors in a "best case" scenario over the long run.

Instead of buying richly valued stocks, a more productive strategy could be to buy cheaper stocks that are less popular among investors. They may offer much larger margins of safety, as well as more attractive capital growth prospects.

As Marks once said, "The most dangerous thing is to buy something at the peak of its popularity. At that point, all favourable facts and opinions are already factored into its price and no new buyers are left to emerge."

Respecting the economic cycle

It is easy to lose sight of the economic cycle when stock prices are moving higher. However, no bull market and no economic boom has ever lasted forever. They have always been followed by bear markets and recessions, respectively.

Therefore, even though the Federal Reserve has stated that it will continue to stimulate the economy should it experience further difficulties, rising stock prices will not continue uninterrupted over the long term.

In my opinion, you should prepare for a bear market and a recession today by ensuring that your holdings can survive difficult trading conditions. For instance, companies with manageable leverage, a competitive advantage over their sector peers and valuations that are not excessive may produce relatively strong performances in the long run. They may be less impacted by factors such as weaker GDP growth and deteriorating investor sentiment towards the stock market.

As Marks once said, "If one is approached with a deal predicated on cycles having ceased to occur, remember that invariably that's a losing bet."

Taking a long-term view

Even though the current bull market will eventually come to an end, overvalued stocks could become even more expensive in the meantime. Therefore, avoiding popular stocks that trade on rich valuations and buying cheaper companies may not be a profitable strategy in the short run.

However, in the long run, a value investing approach can lead to higher returns. Value investors such as Marks have previously avoided speculating on richly-valued stocks in a bull market. Even though this has led to short-term underperformance for their portfolios at times, sticking with that strategy over the long term it has allowed them to allocate their capital more efficiently.

As Marks once said, "If you've settled on the value approach to investing and come up with an intrinsic value for a security or asset, the next important thing is to hold it firmly. That's because in the world of investing, being correct about something isn't at all synonymous with being proved correct right away."

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

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