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Robert Stephens, CFA
Robert Stephens, CFA
Articles (431) 

Howard Marks: Overpaying for Stocks Is a Dangerous Game

Buying undervalued shares represents a more efficient allocation of capital

December 16, 2020

The S&P 500 has gained two thirds in value since reaching a three-year low in March. A key catalyst for its rise has been increasingly rich valuations across the stock market. They have largely been catalyzed by improving investor sentiment.

In my view, some valuations currently present in sectors such as technology are becoming very difficult to justify. They assume little or no disappointment will take place in 2021. This may not necessarily be the case while coronavirus risks are ongoing and the likelihood of regulations on big tech seems to be increasing.

Therefore, buying richly-valued stocks could be a dangerous game. Investor sentiment is very unlikely to improve indefinitely, which could lead to disappointing returns from today's overvalued stocks.

It's never different this time

The past 12 months have provided evidence that asset prices can diverge significantly from their intrinsic values. In the first quarter of 2020, many stocks traded at large discounts to their intrinsic values due to fears regarding the economic outlook. However, today, the reverse seems to be true. Many stocks offer little or no margin of safety.

The past performance of the stock market shows that a divergence between price and value never lasts forever. For instance, the average bull market since 1945 has lasted for around 1,000 days. This may mean that today's investor optimism has further to run, since the current bull market is only around nine months old. However, it highlights the risk in buying overvalued assets in the hope that they will become even more overvalued further down the line.

Eventually, investor sentiment will deteriorate as a result of some economic, political or other reason. When that situation occurs, stocks that lack a margin of safety could be affected to a greater extent than today's undervalued companies.

Howard Marks on the importance of value investing

Oaktree Capital cofounder Howard Marks (Trades, Portfolio) has previously highlighted his aversion to buying overvalued assets, and the risks that a growth strategy can involve:

"Every once in a while, an up-or-down-leg goes on for a long time and/or to a great extreme and people start to say 'this time it's different'. They cite the changes in geopolitics, institutions, technology or behaviour that have rendered the 'old rules' obsolete. They make investment decisions that extrapolate the recent trend. And then it turns out that the old rules still apply and the cycle resumes. In the end, trees don't grow to the sky, and few things go to zero."

I think Marks' words are very applicable to today's stock market outlook. Investor sentiment has improved to such a large extent over recent months that major economic and political risks are being overlooked and even ignored. This is leading to extremely unattractive valuations among today's popular stocks that may leave them exposed to an inevitable future downturn.

In my opinion, the most logical approach to take in today's market is the same as in any investing environment. Buying undervalued stocks in market segments that are less popular among investors could equate to a more efficient allocation of capital. They may be less impacted by market volatility in 2021. They could also offer a more obvious path to capital growth than their overvalued peers that are reliant upon continuing investor irrationality to deliver positive returns.

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