The stock market's 70% rise since March 2020 has at least partly been catalyzed by improving investor sentiment toward growth stocks. For instance, many technology companies now trade at rich valuations because investors are optimistic about their chances of delivering high profit growth.
While their futures may be positive from a profitability perspective, their stock valuations may limit the potential for investors to experience capital growth. Even companies that can produce strong earnings growth may make poor investments if they are purchased at a price that offers little or no margin of safety.
Therefore, ensuring that any growth stock trades at a reasonable price prior to purchase could be an efficient means of allocating capital.
A best-case scenario is already priced in
Earnings forecasts for a wide range of companies have improved dramatically over the past six to nine months. Investors have gradually become increasingly upbeat about their prospects as monetary policy and fiscal stimulus packages have helped to support the outlooks for many industries.
However, rising stock prices mean investors may now be factoring in a "best-case scenario" for many businesses. This means investors may not have priced in the potential for underperformance caused by risks ranging from fiscal changes under a new administration to further challenges posed by the coronavirus pandemic.
Therefore, even if today's popular stocks deliver high profit growth in the future, they may disappoint investors' lofty expectations. This means there is a real threat of companies delivering strong profit growth, and yet experiencing stock returns that are below the market average as a result of today's overexuberance.
Focusing on growth at a reasonable price
Former fund manager Peter Lynch has frequently sought to buy stocks that offer improving financial outlooks at prices that do not fully reflect their future prospects. As he once said:
"If the P/E of Coca-Cola (KO, Financial) is 15, you'd expect the company to be growing at about 15% a year, etc. But if the P/E ratio is less than the growth rate, you may have found yourself a bargain. A company, say, with a growth rate of 12% a year (also known as a '12% grower') and a P/E ratio of 6 is a very attractive prospect."
Undoubtedly, earnings forecasts can be subject to change. That's perhaps particularly true at the moment as a result of the uncertain economic outlook and its potential impact on a variety of industries. Therefore, by following Lynch's advice and obtaining a margin of safety, it is possible to allocate capital more efficiently through reducing risk in case the future performance of a company disappoints versus today's expectations.
Finding today's growth opportunities at fair prices
Searching outside of today's most popular stocks could be a means of unearthing companies that offer growth at a reasonable price. They may not have risen to market valuations that assume no unforeseen challenges will occur over the next few years.
Likewise, searching for value investing opportunities in sectors with reliable track records could yield stocks that offer larger margins of safety. They may be less impacted by an uncertain economic environment, and may be worth a premium valuation due to their resilient business models.
Meanwhile, companies that do not necessarily need to change their strategies or business models in response to recent events could offer greater earnings stability than today's most popular stocks. They may not require large amounts of investment to maintain their market positions, allowing them to capitalize on a long-term economic recovery through delivering rising profits that lead to higher stock market valuations.
Disclosure: The author has no position in any stocks mentioned.
Read more here:
- Howard Marks: Don't Forget About the Market Cycle
- Warren Buffett: Use Fundamentals, Not Formulas, When Investing
- Seth Klarman: A Margin of Safety Is Crucial in Bull Markets
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