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

Seth Klarman: A Margin of Safety Is Crucial in Bull Markets

Avoiding overvalued stocks could lead to more efficient capital allocation

January 13, 2021

The stock market's sharp rise following the Covid-19 crash is showing little sign of slowing down. The S&P 500 has gained 4% in the past month due to improving investor sentiment. This is highlighted by the Volatility Index (VIX), which now stands at a similar level to where it was a year ago.

In my view, a rising stock market can be dangerous. It can lull investors into a false sense of security that means they overlook excessive stock valuations and fail to question overly-optimistic forecasts.

Since no bull market has ever lasted forever, and many shares appear overvalued at the moment, a value investing strategy that focuses on obtaining a margin of safety could be useful. It may help avoid overpriced stocks and allow an investor to capitalize on lower valuations further down the line.

High valuations may not last forever

The past performance of the stock market casts doubts on its potential to make uninterrupted gains in future. It has risen 70% since reaching its lowest point in March 2020. Even though that is less than the 112% average gain during previous bull markets, some companies are trading on valuations that are significantly higher than their long-term averages. This may indicate that they offer little, or even no, margin of safety.

Those valuations are being supported by earnings forecasts that are becoming increasingly optimistic. Improving investor sentiment is causing optimism in sectors such as technology that may be excessive, given the uncertain economic prospects that may be ahead. Even if large-cap tech stocks meet their financial forecasts, their share prices may not deliver capital growth because investors are already anticipating a "best case" scenario.

Holding cash and waiting for opportunities

Investors may be better off avoiding overvalued stocks in this bull market. Further, buying stocks that are priced at lower levels could mean less risk due to the presence of a margin of safety. This may also provide greater scope for capital growth in the long run.

If an investor struggles to find value investing opportunities in today's market, a strategy that holds cash and waits for lower prices may be more favorable to purchasing overvalued shares, in my view. The average bull market has lasted for less than three years in the past. However, the range in this data set is very wide. Therefore, the current bull market could come to an end well before its age reaches the historic average.

This strategy was neatly highlighted by Baupost cofounder Seth Klarman (Trades, Portfolio). He previously summarized key parts of his investing strategy:

"Margin of safety, by always buying at a significant discount to underlying business value and always giving preference to tangible assets over intangibles. By replacing current holdings as better bargains come along. By selling when the market value comes to reflect its underlying value and by holding cash, if necessary, until other attractive investments become available."

A patient approach

Low interest rates mean that holding cash is likely to produce very disappointing returns this year. Investors who sell overvalued stocks and hold cash while awaiting lower prices could easily become impatient. This feeling may be heightened should the stock market continue its recent rise.

However, a patient approach that focuses on the long term could be a means of allocating capital efficiently. It may help to avoid the pitfalls of purchasing stocks that lack a margin of safety. It could also provide greater opportunities to take advantage of the next bear market, which history suggests is never too far away.

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