Value Investing in a Bull Market

Some thoughts on where we stand in today's stock market

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I am currently looking at a company that has a pretty good underlying business. It has grown like a weed over the past decade and has attractive economics. The only problem is the stock trades for roughly 45 times forward earnings (based on management’s guidance). Back in 2014, the price to earnings (P/E) multiple for the stock was roughly 35 times forward. Back in 2011, the P/E for the stock was roughly 25 times forward. The multiple Mr. Market is asking me to pay has nearly doubled in six short years. It is difficult to get too excited when you see something like this.

To a certain extent, we have seen this in U.S. equity markets as a whole. At the end of 2011, the S&P 500 traded for 1,260, or roughly 13.0 times trailing operating earnings. At a recent 2,415 (up 90% or so since the end of 2011), the S&P 500 is trading at roughly 20.6 times 2016 operating earnings of $117 per share. Of the price gains recorded by the S&P 500 since 2011 (not including dividends), roughly two-thirds are attributable to multiple expansion. You can quibble with the numbers if you would like (everybody has a different number for S&P 500 earnings), but the broader point stands: a significant portion of the gains for the S&P 500 over the past five years are attributable to the increase in the multiple investors are willing to pay for a dollar of earnings.

For someone like myself, this has been a frustrating environment as of late. Most of the companies I have looked at lately are simply too expensive. I am still finding good businesses, but I need them to fall 15%, 20% or more before I would be willing to buy them. Lately, more often than not, they've gone the other direction (even when the quarterly results are uninspiring). It is discouraging when that happens over and over and over again.

Unsurprisingly, in an environment where there appears to be ever-expanding optimism (at least as reflected in equity prices), companies that are set to revolutionize the world and dominate for decades to come (if all goes according to plan) are in high demand. Investors tend to expand their time horizons when the waters are calm. People buy into the narrative that all will be well if they can just hang on long enough (whether or not they will be able to when there is blood in the streets is another question). Positive price action reinforces the belief that valuation is of secondary concern (if at all); when you can find the truly “great” companies, there is almost no price that's too high. Companies that fit this mold are killing it – and pulling the indices along with them.

If you are like me, you live somewhere near the other end of the spectrum: holding cash and selling fairly valued stocks as prices climb (admittedly, I have moved more gingerly than I would have originally expected due to a sizable cash balance and the tax implications of selling certain positions). That is a difficult setup if you're concened about straying too far from a market that keeps racing higher. The likely outcome is underperformance, possibly by a wide margin. Of course, that's the cost of admission if you hope to stand out from the pack in the other direction.

So what does any of this mean? I guess this is my way of saying you're not alone if you feel left behind in this phase of the cycle. I'd also say you should prepare (mentally) for it to continue; nobody knows when or how this ends. The company I mentioned in the opening paragraph has changed very little over the past few years. Either Mr. Market was very wrong to let the stock trade at 25x or he has currently lost his marbles in the other direction. I guess time will tell.

As I have consistently said in the past, I do not want to overreach with what I am saying here. My simple point is that the trend – not necessarily where we are sitting at today – is unsustainable. Market prices cannot outpace underlying business values in perpetuity.

I think there are pockets of value. For example, I just bought some Wells Fargo (WFC, Financial), which I think looks pretty good on an absolute basis (and even better on a relative basis).

But the broader opportunity set continues to shrink. I thought Mr. Market was offering up some decent bargains five years ago; now, I think they are few and far between. For me, the game plan is the same as it has been for some time: stay patient and keep looking. I believe my investment process is likely to work long term despite the inevitable pockets of weak performance.

I will close with something Warren Buffett (Trades, Portfolio) said back during the Partnership days:

“When the game is no longer being played your way, it is only human to say the new approach is all wrong, bound to lead to trouble, etc. I have been scornful of such behavior by others in the past. I have also seen the penalties incurred by those who evaluate conditions as they were – not as they are. Essentially I am out of step with present conditions. On one point, however, I am clear. I will not abandon a previous approach whose logic I understand (although I find it difficult to apply) even though it may mean foregoing large and apparently easy profits to embrace an approach which I don’t fully understand, I have not practiced successfully and which, possibly, could lead to substantial permanent loss of capital.”

Disclosure: Long WFC.

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