Investors currently have to deal with one of the most unusual market environments in history. The coronavirus outbreak has devastated the global economy. As the outbreak proceeds to rumble on, it seems as if many businesses and economies will continue to struggle.
However, this devastation and uncertainty is not currently reflected in asset prices. On some metrics, the S&P 500 is now more expensive than it has ever been.
Tech outperforms
Tech stocks have driven the index's performance. The ten largest companies in the index have accounted for virtually all of its performance this year. These are all in the technology sector.
The pandemic has forced businesses all over the world online. This has had an enormous impact on the demand for technology. Companies like Amazon (AMZN, Financial) have provided an invaluable service during these trying times.
Following this performance, virtually every technology stock is trading at a premium valuation. The challenge investors face is establishing whether or not these companies are worth paying for.
In many developed markets, brick-and-mortar retail still accounts for the bulk of retail sales. What's more, many companies are not digitally up-to-date. This presents an enormous market for the market's highest-flying tech businesses. To put it another way, these companies may look expensive now, but they could have a long runway for growth in front of them.
So, the decision investors face is, should I buy highly valued tech stocks and hope for future growth, or buy cheap, struggling businesses and hope they turn around?
Value vs. Growth
As a value investor, I am naturally drawn to cheap businesses, although I'm not too sure in the current market. Disruption and technological change have disrupted many business models over the past few years, and this trend has only accelerated in 2020. Avoiding value traps is one of the challenging aspects of value investing. With the pace of disruption accelerating, it has become harder than ever to avoid value traps.
You need to be on the ball and alert to changes in particular sectors to stay ahead of the game and the competition. Even well-established global consumer goods giants such as Pepsi (PEP, Financial) and General Motors (GM, Financial) are struggling. They have been overwhelmed by the sheer volume of cash being pumped into smaller peers and upstarts, which are now eroding market share.
Picking winning stocks has always been an essential part of investing, but now more than ever, it's vital to avoid losers as well. What does a loser look like? Companies facing structural change or businesses that are not investing enough to stay ahead of the competition could be examples.
Not investing enough
How do we know if a company is not investing enough? There's no correct answer to this question. However, companies with lots of debt tend to underinvest. Companies that rely on financial engineering also tend to underspend on planning for the future.
The world is becoming more interconnected, and that's good news for the companies that supply vital technology. Finding these businesses is the hard part. There's also more information out there for other investors. To put it another way, it's hard to find winning companies. It's only getting harder.
Investors face one of three choices against this backdrop. They can either give up and follow the momentum trade, buying tech stocks and hoping for the best. Another strategy could be to buy the S&P 500, sit back and ignore individual businesses.
The third avenue is to buy what you know. Avoid tech if you don't understand the sector and buy stocks that you understand enough to know if they have a strong competitive advantage and are investing in the future. That has always been and will remain, the best way to evaluate and invest in businesses. If it's too hard, you might do better buying the S&P 500.
Disclosure: The author owns no share mentioned.
Read more here:
- Charlie Munger: Copying Other Investors Can Be a 'Good Idea'
- Warren Buffett: Opportunity Cost in Times of Uncertainty
- An Alternate View on Why Berskhire Hathaway Is Buying Snowflake
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