I’ve noticed a lot of investors have been loath to invest new capital in the stock market over the last year or so in fear that a correction would occur and they’d lose money.
First, what’s a correction?
Investopedia defines it as the following:
A reverse movement, usually negative, of at least 10% in a stock, bond, commodity or index to adjust for an overvaluation. Corrections are generally temporary price declines interrupting an uptrend in the market or an asset. A correction has a shorter duration than a bear market or a recession, but it can be a precursor to either.
Now, I’ll note that corrections are generally healthy. An uptrend left unchecked could lead to irrational exuberance. And like anything that reverts too far from its mean, the snap back could be quite harsh.
But I look forward to corrections for quite a different reason. And that reason is so that I can buy cheaper stocks. If a stock is $50 today, but a correction tomorrow brings it down to $45, I’m looking at the ability to buy more shares with the same amount of money. And since price and yield are inversely correlated, that also means (unless the dividend was cut in the interim) that I’ll receive more dividend income on my money. Now, one should be paying attention to value, not price. Price is just a number (that changes almost every minute of every market trading session) that Mr. Market decides something should be bought or sold for. Value, on the other hand, actually tells you what something is worth.
Assuming that a correction is coming to correct overpriced stocks, one would then assume that prices after a correction would be generally more in line with respective values. But that’s assuming all stocks are priced one and the same, relative to their valuations. And I don’t believe that.
The S&P 500 Appears Overvalued
The broader market has not only approximately doubled over the last five years, but it’s done so in almost one constant straight move up. We’ve had a couple drops along the way – notably in the summer of 2011, the spring of 2012, and the late fall of 2014 – but it’s largely been up, up, up.
What that means is that it’s easy for stock prices to move further away from their fair value as a group. While the broader market has doubled over the last five years, a lot of the earnings of companies I follow and invest in haven’t. So you could make a case that stocks were just plain undervalued at the beginning of that period, but I think you can also now make a case that, in aggregate, stocks are expensive now.
You see that with the valuation metrics of the S&P 500.
The S&P 500’s P/E ratio (using TTM EPS) is currently 20.46. That’s about 30% higher than the long-term mean of 15.54. If you use the Shiller P/E ratio, which is thought to be even more accurate because it smooths out one-year fluctuations in earnings, it’s currently 27. That’s more than 60% higher than the long-term mean. So I think a case could be made that we’re sitting on an expensive market here.
Warren Buffett (Trades, Portfolio) has gone on record saying that he believes the best way to check the broader market’s valuation is to look at total stock market capitalization against GNP.
In a speech given in 2001, he stated:
If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200% — as it did in 1999 and a part of 2000 — you are playing with fire.
We can see that total stock market cap/GDP (works out to be quite similar) is just over125%.
Certainly not cheap. Although, the ratio was 133% back when Buffett gave that speech in 2001 and he stated:
I would expect now to see long-term returns run somewhat higher, in the neighborhood of 7% after costs.
“Somewhat higher” is in reference to a similar speech he made back in 1999, when the ratio was much higher and Buffett thought long-term returns would thus be lower. So this ratio apparently doesn’t indicate the need for panic. Furthermore, Buffett just spoke on this subject quite recently when asked about it at the Berkshire Hathaway Inc. (BRK.B)annual shareholders meeting and stated that he only views stocks as currently expensive if rates start to rise. Otherwise, they’re not particularly cheap or particularly expensive.
Nonetheless, I think a case could be made that the broader market is overvalued right now – perhaps even significantly so. And seeing how rates will more likely rise than fall over the intermediate and long term, that would indicate that even Buffett’s recent commentary indicates overvaluation.
Looking At The Stock Market Like A Store
However, I don’t really concern myself with the valuation of the broader market whatsoever. And that’s because I’m not buying the stock market. I’m buying individual stocks whose individual prices have to be weighed against their respective intrinsic values.
I look at the stock market like a store. It’s a market filled with merchandise. Some merchandise is worth more than other merchandise. And some merchandise is cheap, while other merchandise is expensive. And sometimes there doesn’t appear to be any reason for this discrepancy.
It’s been said that it’s a market of stocks, not a stock market. I believe that’s the best way to look at the stock market. And that’s because not all stocks trade in lockstep.
Look, the market is my favorite store of all. I love shopping for stocks. While some might love shopping for shoes or spending all day in an electronics store, I could spend all day looking at stocks. Even better, my merchandise pays me to own it!
But just because I’m shopping for stocks and not shoes doesn’t mean that I’m not heading to the clearance section. If I need clothes, I’m going to buy the highest-quality merchandise at the best price I can, relative to the value of that clothing. So I’ll head to the back of the store, looking for discounted merchandise that nobody wants. Spending too much time at the front of the store might give you the feeling that the entire store is expensive. While that may or may not be true, that doesn’t mean all merchandise in theentire store is expensive all at the same exact time.
And just because the entire store isn’t on sale, that doesn’t mean specific merchandise isn’t on sale.
Would You Know The Correction If You Saw It?
There are a lot of problems with waiting for a correction, and I’ll explain why I don’t bother.
First, when you’re not investing cash in high-quality dividend growth stocks that grow your wealth and income, you’re technically losing money to inflation by not turning that cash into increasing cash flow. Your snowball slows and financial independence is potentially being put off.
Now, you could make the case that there’s an opportunity cost with investing cash rather than sitting on it, awaiting a sale across the whole store at which point in time your capital would go further. And maybe that’s true. But would you know the extent of the correction if you saw it? If the market drops by 10% this week, will you invest your cash? Or will you await an even better sale, thinking that the 10% drop portends even more sales? And how long do you sit on cash? I’ve read comments by some investors at various investment community sites inferring that they’ve been sitting on cash for years now, awaiting a major correction that still hasn’t manifested itself. Who’s realizing the opportunity cost? And how much does the market have to drop just for those sitting on cash to break even had they invested their money from the get go?
Timing the market is impossible. I’ve never heard of anyone that’s ever been able to do it with any regular consistency and success. But the good news is that it’s not necessary to be incredibly successful in regards to growing wealth and passive income. Long-term investors have time in the market, rather than timing the market, at their disposal.
If the market drops by 10% at some point here in the near future, I’ll be jumping for joy. While not all stocks trade in lockstep, a changing tide tends to affect all boats to some degree. But I won’t change my investing habits, and I’m not holding my breath. Furthermore, I won’t sit on cash if it were to happen, trying to anticipate future broad market drops based on what’s already come to pass. I’ll still be deploying capital just as I always have – regularly and consistently in the highest-quality stocks at the best possible valuations I can find at any given time.
However, a market correction isn’t necessary to find deals in the market. In fact, many corrections at the individual stock level have already occurred thus far in 2015. And you might not even have noticed. So if you’re awaiting a correction to deploy capital, many high-quality stocks have already corrected well past the traditional 10% yardstick to be considered a “correction” this year. I look forward to individual stock corrections just as much, if not more than, broader stock market corrections.
Discounted Merchandise
I’m going to list a few high-quality dividend growth stocks that are down more than 10% YTD and have “corrected” to various degrees in 2015. Now, price and value are different. Not every 10% drop in price necessarily means a stock is then attractively valued. If a stock is overvalued by 20% and subsequently drops by 10%, it’s still overvalued. But these names are solid starting points for further consideration, with some of them appearing substantially undervalued and others appearing somewhat fairly valued after prior periods of overvaluation. The store might be expensive, but I think these stocks represent merchandise that’s hanging out at the clearance section at the back of the store.
Union Pacific Corporation (UNP, Financial)
This stock is down more than 14% YTD from previous highs that didn’t necessary indicate wild overvaluation. I’ve been actively buying this stock at a rather aggressive rate recently, and my analysis concluded that it’s potentially 16% undervalued right now. A high-quality railroad with built-in competitive advantages that are just incredible, this is a business I’m glad to own a slice of. Norfolk Southern Corp. (NSC, Financial) is another high-quality railroad that’s dropped by more than 15% YTD. In fact, most of the major railroads are down quite a bit this year, which, in my view, is a great long-term opportunity.
Wal-Mart Stores, Inc. (WMT, Financial)
This is a stock that’s now back on my radar after falling from fairly lofty levels earlier this year. It’s now down almost 15% YTD, and now trading at a price that I think is far more in line with its fair value. I took a look at the stock back in late April and concluded that there was a lot to like, but the valuation was too high as the stock seemed to be worth about $70. Well, the stock has come down quite a bit even over that short period of time and I think it’s a pretty solid long-term investment here. Not overly cheap, but buying WMT at under15 times TTM earnings and planning on holding for the next 20 or 30 years seems like a strong idea to me.
Omega Healthcare Investors Inc. (OHI, Financial)
This is another stock I’ve been very interested in lately. It’s fallen just under 12% thus far in 2015, and now trades for a P/FFO ratio of just over 12 with a yield of 6.28%. This company has been an incredible investment over the last 10 years and I see no reason why that won’t continue for the foreseeable future. It’s the major player in its space here in the US and the long-term tailwinds are just incredible. I added to my position just last monthand I’m currently strongly considering doing so once again this coming week.
W.P. Carey Inc. (WPC, Financial)
This international real estate firm checks off a lot of boxes for me, from yield to quality to growth. And its stock is down more than 12% YTD. I think it’s an incredibly compelling opportunity, which is why I’ve been particularly active with this stock. I initiated an equity stake in the company back in April and I’ve since added to it twice. A lot of “traders” (I use that term since long-term investors shouldn’t be concerned about short-term changes in macroeconomics) seem to be concerned with rising rates and how REITs will be affected (specifically, how they’ll be negatively affected as an entire group). You know, because their buildings evaporate, their tenants stop paying rent, the fundamentals strongly deteriorate, and REIT stock prices (they all behave the same, right?) drop like rocks when rates rise. Or not.
Procter & Gamble Co. (PG, Financial)
One of the prototypical dividend growth stocks with an amazing 59 consecutive years of dividend raises, it’s struggled mightily as of late – both the company and a stock. But is the drop of 15% YTD warranted? I think the stock got a little ahead of itself at over $90/share, but it’s a pretty decent long-term idea here at about $77/share, currently sporting a yield of3.43%. I don’t think PG is the cheapest stock around, but its legacy, brand lineup, and quality are really fantastic. Recent initiatives designed to spur growth are exciting, so this stock could quickly grow into its valuation and shoot right past it. I wouldn’t go crazy here, but PG is back on my radar to some degree after a rather lengthy absence.
Hershey Co. (HSY)
This is a stock I’ve long ignored because, frankly, it’s been expensive over the last few years. And the growth never seemed to warrant the sky-high valuation, especially since somewhere around early 2013. But it’s now down 12.5% YTD, which has allowed the stock’s price and value to come back into alignment. I was recently discussing this stock with a reader and then I took a better look at it just a few days ago. The growth isn’t outstanding, but you’re getting a consistent company with a very simple business model that’s very unlikely to change much over the next 50 or so years. Dominant market share here in the US with great brands offers a lot to like, although recent stumbles in China are slightly concerning. Nonetheless, I think it’s roughly fairly valued here, which appears to be an opportunity to buy into one of the oldest and highest-quality consumer companies around with seemingly few immediate headwinds.
National Oilwell Varco, Inc. (NOV)
There’s no doubt that the energy sector is under fire (pun intended) lately. But some of the drops, especially in the oilfield services industry, seem to be unwarranted. NOV is down more than 25% YTD, now trading for a P/E ratio of 9.44 and a yield of 3.76%. They’re still working through their backlog and that’s buoying earnings for now. However, even a massive drop in earnings still offers a lot of long-term value here. It’s a volatile stock and there could be more short-term pain ahead, but I think the long-term potential is extremely promising here.
Royal Dutch Shell PLC (RDS.B, Financial)
Another energy name, Shell’s stock has fallen over 15% this year. Like all the other supermajors, a good chunk of the drop is warranted due to the change in underlying commodity pricing that started last year. Furthermore, Shell actually has some of the weakest fundamentals of its peer group. However, it does have some redeeming qualities like a lower valuation compared to the big US-based supermajors as well as a much higher yield. At 6.38%, Shell’s yield is among the highest I track across all high-quality stocks. I’m not sure we’ll see a dividend raise from Shell this year, especially if commodity pricing doesn’t improve. But with that high of a yield, you’re already getting a very healthy income component attached to this stock.
Conclusion
The broader market does appear to be overvalued right now. But the market has seemingly been overvalued for some time now, with the Shiller P/E ratio being well above its long-term mean for more than five years now. Waiting for that reversion means you’d be sitting on cash for that entire time, missing out on the opportunity to own pieces of wonderful businesses that will very likely reward you with growing dividends and growing wealth for decades to come.
The stock market is basically a market, or store, like any other, filled with merchandise that one can purchase during regular business hours. While I’d love a cheaper store, I find it not all that difficult to walk to the back of the store and find the discounted merchandise that others are apparently less interested in. Some discounted merchandise isn’t particularly high quality, but other merchandise, like that listed above, is.
I leave you with some eternal wisdom by Buffett – an excerpt of a speech given in late 1999 on the valuation of the stock market (this mirrors my own philosophy down to the word):
At Berkshire we focus almost exclusively on the valuations of individual companies, looking only to a very limited extent at the valuation of the overall market. Even then, valuing the market has nothing to do with where it’s going to go next week or next month or next year, a line of thought we never get into. The fact is that the markets behave in ways, sometimes for a very long stretch, that are not linked to value. Sooner or later, though, value counts.
Full Disclosure: Long UNP, NSC, WMT, OHI, WPC, PG, and RDS.B.
What about you? Waiting for a correction? Would you know the extent of it when you saw it? Value individual companies rather than the market? Think these stocks have corrected enough to warrant a look?
Thanks for reading.
