Large-cap technology stocks have become increasingly popular in the current bull market. This has driven their prices higher, and could mean that they lack margins of safety.
Therefore, I think investing in unloved companies that offer lower valuations is a more efficient use of your capital.
Peter Lynch has a long track record of using this strategy when apportioning his capital. His focus on buying fundamentally sound businesses at low prices could be a key reason for his Magellan fund's market-beating 29% annualized returns between 1977 and 1990.
Buying stocks versus buying companies
There is a vast difference between a great company and a great investment opportunity. For example, a business may be dominant in its market and have the potential to deliver high profit growth in the long run. Likewise, you may be a very satisfied customer of a specific company and believe that it has a wide economic moat.
However, in my view, these are insufficient reasons on their own to merit buying shares in a company. A great company with a competitive advantage over its peers can turn out to be a poor investment. Therefore, identifying attractive companies is a sound first step for any investor to take, but it should then be followed by thorough analysis of its fundamentals and valuation to determine whether it is an appealing investment opportunity.
As Lynch once said, "Peter Lynch doesn't advise you to buy stock in your favorite store just because you like shopping in the store, nor should you buy stock in a manufacturer because it makes your favorite product or a restaurant because you like the food. Liking a store, a product, or a restaurant is a good reason to get interested in a company and put it on your research list, but it's not enough of a reason to own the stock."
Looking beyond today's stock prices
The rising prices of large-cap technology stocks means that many of them currently trade on high valuations. For instance, Apple (AAPL, Financial) has a price-earnings ratio of 37, while Facebook (FB, Financial) has a price-earnings ratio of 35.
Investors who assume that today's stock market prices are efficient may believe that high valuations indicate greater growth potential. However, high valuations may limit future capital gains because they represent a best-case future for the company in question that may not be met.
Therefore, buying stocks with lower valuations could represent a more productive use of your capital. The stock market can be highly inefficient, which creates opportunities for investors to purchase undervalued stocks that are temporarily unpopular among their peers.
As Lynch once said, "If my favorite internet company sells for $30 a share, and yours sells for $10, then people who focus on price would say that mine is the superior company. This is a dangerous delusion. What Mr. Market pays for a stock today or next week doesn't tell you which company has the best chance to succeed."
Focusing on long-term gains
Popular stocks may continue to be in high demand among investors in the near term. This could mean that avoiding them to invest in unloved stocks is not a profitable strategy in the short run.
However, in the long run, maintaining a value investing strategy is likely to pay off. Eventually, companies with sound fundamentals are likely to become more popular among investors. Their rising profitability and growth potential could lead to stock price gains that outperform the wider market.
Lynch has always focused on the long term when managing his portfolio. As he once said, "It takes remarkable patience to hold on to a stock in a company that excites you, but which everybody else seems to ignore. You begin to think everybody else is right and you are wrong. But where the fundamentals are promising, patience is often rewarded."
Disclosure: The author has no position in any stocks mentioned.
Read more here:
- Seth Klarman on Value Investing in a Bull Market
- Howard Marks: Approach Bull Markets With Caution
- Warren Buffett: 3 Investment Principles for Bull Markets
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