Many investors are buying stocks at the moment because they have recently risen in price. Indeed, a strategy of momentum investing that seeks to capitalize on the continuation of recent trends, counting on the bull market to continue, seems to be becoming more popular.
However, buying a stock because it has upward momentum could represent an inefficient use of capital. In fact, it could be an illogical strategy because buying at a higher price can provide less room to make a capital gain versus investing at a lower price, while also increasing the downside risk.
In my view, focusing on company fundamentals and buying undervalued shares is a more productive strategy than seeking to follow recent market trends.
Focusing on company fundamentals
Many of today's popular stocks that have risen in price appear to have unattractive fundamentals. In a number of cases, their valuations are extremely high and are only based on forecasts that are exceptionally optimistic. Therefore, their share prices could come under a large amount of pressure should their financial performances prove to be below investor expectations.
Not all companies have weak fundamentals at the moment. Some businesses have a mix of a solid balance sheet, a wide economic moat and a strategy that is capable of adapting to changing consumer tastes in the current fluid economic environment. Buying them when they trade at prices that appear to undervalue their prospects could offer a significantly more appealing risk/reward opportunity than investing based on a stock's recent momentum.
A forgotten strategy?
As with many investment principles, a fundamental-focused strategy is easily forgotten by increasingly upbeat investors during a bull market. However, the market cycle has not disappeared. During periods of extreme highs, it can be worth remembering the views of investors who have experienced multiple bull and bear markets during their careers.
One such individual is the father of value investing, Benjamin Graham. As he once said:
"The one principle that applies to nearly all these so-called 'technical approaches' is that one should buy because a stock or the market has gone up and one should sell because it has declined. This is the exact opposite of sound business sense everywhere else, and it is most unlikely that it can lead to lasting success in Wall Street. In our own stock-market experience and observation, extending over 50 years, we have not known a single person who has consistently or lastingly made money by thus following the market."
Investing in today's market
Opportunities to buy companies with sound fundamentals at low prices may be more limited after the stock market's recent rise. Therefore, holding cash and waiting for buying opportunities to come along could be a more productive use of capital over the long run.
It may mean that an investor avoids today's overpriced stocks. They may be hardest hit in the next bear market, since their narrow margins of safety may assume uninterrupted growth that fails to materialize. It could also provide an investor with the chance to buy quality companies at lower prices in future.
Overcoming an opportunity cost
Of course, in the short run the current bull market could persist. This may make the task of avoiding following the market even more difficult, since holding cash could represent a significant opportunity cost.
However, the stock market's track record of 14 bear markets over the past 75 years shows that a decline is never far away. Predicting the next market fall may not be possible due to the wide range of factors that can impact on its price level. Therefore, having a fundamental-focused strategy may enable an investor to allocate their capital efficiently at all times on a long-term basis.
Read more here:
- Seth Klarman on the Benefits of Dollar Cost Averaging
- Warren Buffett on the Importance of Holding Cash
- Peter Lynch on Obtaining Growth at a Reasonable Price
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