The stock market's 60% rise since March may cause some investors to believe that stock prices could make uninterrupted future gains. This view may lead them to invest in overvalued stocks that lack a margin of safety.
This goes against the strategy used by Oaktree Capital's Howard Marks (Trades, Portfolio). His focus on buying undervalued stocks could protect him against an inevitable bear market and lead to a more efficient allocation of capital.
Bull markets never last forever
It is easy to wrongly assume that recent market trends will continue forever. Investor sentiment has improved significantly in recent months, as evidenced by the VIX now being at a similar level to where it was prior to the market's decline in February and March. This has contributed to increasingly upbeat earnings forecasts and rising stock valuations that have shown little sign of returning to levels that more accurately reflect company fundamentals.
However, market cycles have not disappeared. Bear markets are still a normal part of the investment cycle. They have occurred 14 times since 1945 and have delivered a 36% average decline in stock prices when they have taken place. Therefore, investors who assume they can buy overvalued stocks today and sell them at even higher prices later on are likely to experience major disappointment further down the line.
Investing in undervalued securities
Predicting when a bear market will occur is nearly impossible. There are a vast number of variables that can quickly cause a market decline without prior warning. Therefore, obtaining a margin of safety in any investment may be a more pragmatic approach. This strategy is used by Marks, who previously discussed the importance of investing in undervalued stocks:
"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."
The practicalities of a margin of safety
Arguably, undervalued stocks may be impacted to a lesser extent by a bear market than overvalued stocks. Therefore, a margin of safety protects an investor from downside risks. It also provides greater scope for capital gains since the company in question is being purchased for a price that is less than it is worth.
Undoubtedly, valuing a stock is subjective. However, the process of valuing a stock and requiring a margin of safety instils a discipline that could be particularly useful in a bull market. It may aid you in going against the market consensus and avoiding a mistaken view that recent stock market trends will last forever.
Read more here:
- Warren Buffett: Don't Dance to the Tune of Speculation
- Benjamin Graham: Company Fundamentals Are King
- Joel Greenblatt: Don't Forget the Investing Basics in a Bull Market
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