Thinking Differently - Value Investors & Rising Markets

A quick search on Bing News for “market overvalued” will show a few dozen articles on the first two to three pages (all written in the past two weeks or so) that agree with that conclusion; the consensus has shifted, and the majority now seems to agree that the market is fully valued or overvalued.The interesting thing to watch is how people react to that conclusion.

Let’s start with the viewpoint of the value investor (or how it is so often painted). Value investors are generally focused on one thing: bottoms-up stock selection. A fairly or overvalued stock market isn’t an issue except to the extent that it diminishes the stream of potential investments. Naturally, that’s a likely outcome of a rising market – especially among the large cap, blue chip stocks that are the primary focus of sizable market participants.

Value investors, if true to their craft, only have one choice when they can’t find anything worth buying: wait for better days. Wally Weitz of the $1.1 billion Weitz Value Fund is a great example of such an investor - in a recent Bloomberg Businessweek article, Mr. Weitz noted that a full 29% of his funds’ assets are currently allocated to cash and Treasury bills:

“It’s more fun to be finding great new ideas - but we take what the market gives us, and right now it is not giving us anything.”

Of course, this brings up the average market participants greatest fear: what happens if the markets keep moving higher? This question alone is what separates the value investors from the herd. As Mr. Weitz noted, there isn’t much to be done if the market isn’t giving you any opportunities; if it continues to move against you – and those opportunities become even more scarce – there’s now even less reason to act.

The individual investor simply cannot accept that line of logic; they don’t view equity price movements as a continuing process, one that swings from depression to euphoria and back again, all without signaling when the next change will occur. They see higher stock prices as one thing, and one thing only – missed opportunity; with the benefit of hindsight, they judge their prior action (or lack of one in the case of buying) in the context of a single week or day’s price change – as if they could’ve (or have reason to believe they should’ve) known what would happen before hand. In many cases, they convince themselves that they DID know – and should have trusted their instincts.

This perverse reasoning disregards the fact that stock prices represent partial ownership in a business, with that value dependent upon the future cash that business will bring to its owners. They have no chance of being around a year from now, and don’t care about what the business will earn over the coming decade – they’re more focused on the stock’s trading pattern over the previous 50 days. It’s hard to overstate how much this change in perspective will affect the way you look at stock price movements.

This individual cannot take a 5% price movement higher or lower in stride; the most recent change in equity prices is telling them something important, and will guide their future actions. Let’s return back to our value investor: imagine you’ve found a security where you believe the current valuation implies a forward rate of return of 15% per annum.

Our hypothetical stock is trading at $100 per share – meaning you expect it to reach more than $400 per share ten years down the road ($404.56 to be exact). Now, what happens if the price suddenly jumps 5%, as outlined above? Well, from a starting point of $105 per share, a move to $404.56 in ten years’ time results in a compounded rate of return of 14.44%. Even a move 20% higher – to a starting price of $120 per share – would result in a CAGR just shy of 13% per annum.

Think about that in the context of this year; to date, the S&P 500 has moved higher by a bit over 20%. A move that many are characterizing as quite sizable would only cause our implied CAGR to fall by about two percentage points per annum; and while that certainly is a meaningful difference (especially over time), the impact of that 20% move isn’t as life-changing as recent market commentary might have you believe.

Of course, this could become a slippery slope – and you must set a level where you’ll stop sliding; if you require an ex-ante return of 15% per annum, then this move has just priced you out of the market. With what we’ve experienced in the past few years (in my personal experience, with names like JNJ, PEP, and others), valuations that were implying solid double digit rates of return now appear closer to high single digits per annum – and while that continues to blow away the expected returns on the long bond, it’s not too enticing on an absolute basis.

All that is a lot of rambling to bring me back to the main point: as a value investor, there’s nothing to do but to buy undervalued securities; when you can’t find undervalued securities, then you have no real option but to suck your thumbs. Other market participants cannot stand to underperform; they don’t view rising equity prices as temporary and expanding excess that will one day revert to reality – they see it as missed opportunity.

They are under the illusion that markets will see what they see, and react as such now; reality is much different. Many calling for fully or overvalued markets seem to believe the slowdown or reversal must happen quickly (this can’t go on); while I’d love to see that happen, I understand that the market doesn’t care what I think (you don’t have to look further than the late 1990’s to see that markets can get far more optimistic for a long, long time). The near future is unknown – trying to guess which is more likely (continued gains, a sideways market, or maybe a present day “Black Monday”) and when it will happen is a fool’s errand; accepting the movements and acting when they give you a chance to intelligently do so is a much more promising route.

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