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The Science of Hitting
The Science of Hitting
Articles (532) 

Value Investing in a Bull Market

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

May 25, 2017 | About:

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 (NYSE:WFC), 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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About the author:

The Science of Hitting
I'm a value investor with a long-term focus. My goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio - a handful of equities account for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

Rating: 4.9/5 (15 votes)

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Comments

MCottrill
MCottrill premium member - 2 years ago

Which stock are you referring to in your opening paragraph?

The Science of Hitting
The Science of Hitting - 2 years ago    Report SPAM

MCottrill - It's something I'm still doing work on and it's not that big, so I'd rather not say right now. Send me a PM in a few weeks and I'll be happy to tell you. Sorry!

jtdaniel
Jtdaniel premium member - 2 years ago

Hi Science,

Terrific article. Inability to enjoy watching our accounts appreciate in a bull market must be a common character trait of value investors. It could be for lack of trust as we know within a general range the business value of our holdings. My 15% position in Microsoft has worked out, but its current per-share price just seems out of balance with reality. Hopefully, my valuation is too conservative. As you noted, selling would cause unwanted tax implications so I plan to hold firm and maybe buy more shares in the next bear market.

I agree that there are some pockets of value. Earlier this year I found brief opportunities to buy more shares of Abbott Labs, Berkshire and Wells Fargo. I think there are a few interesting opportunities in health care due to a combination of politics and temporary business issues, so I recently opened new positions in Express Scripts, CVS, and McKesson, Amazon-related panic and economic concerns have rocked many retailers. I recently bought my first shares of Dollar General and Auto Zone, as they do not depend on a booming economy and should be able to co-exist with Amazon.

The Science of Hitting
The Science of Hitting - 2 years ago    Report SPAM

Jtdaniel,

Sorry for the delayed response! Enjoying the beaches over the weekend and did not want to deal with the headache of typing on a cell phone :)

Agree on Microsoft - the price is becoming more daunting for a value investor. I take some comfort in some of the changes we've seen over the past few years (an improved culture under Satya Nadella, focus in the underlying business with sustainable competitive advantages in areas with real growth, and the optionality of huge piles of excess cash, to name a few). That's offset by a valuation that requires more fireworks than were needed when MSFT was at ~$35 per share.

As it relates to pockets of value, we are fishing in the same ponds :) Our portfolios continue to look quite similar. Thanks for the kind words!

vivekjain57
Vivekjain57 - 2 years ago    Report SPAM

Great Article ! It does get frustrating with the cash position and the market keeps inching upwards. I am trying to just keep a constant cash/bonds position as I dont want to miss out on the gains(Capital Appreciation+Dividends) either. Finding value in healthcare like JTDaniel said. I've picked up some CVS, MCK, TEVA, GILD and IBM(recent drop with WB selling).

The Science of Hitting
The Science of Hitting - 2 years ago    Report SPAM

Thanks for sharing your thoughts Vivekjain57!

TonyValdez
TonyValdez - 2 years ago    Report SPAM

Nice article and glad I am not alone! Mr. Market is certainly off his meds and I am blessed to have not moved to cash yet. However, it is frustrating and discouraging but being patatient is the key. Stay the course and this is a good time to turn over rocks and find a wonderful company! Wishing everyone sucessful investing.

The Science of Hitting
The Science of Hitting - 2 years ago    Report SPAM

Thanks for the comment Tony! Keep turning over those rocks :)

Lorddoskias123
Lorddoskias123 - 2 years ago    Report SPAM

Thanks for the article! I have certainly felt discouraged by the current market environment. Glad to know I'm not alone. Glad as well to know that the people I'm with are investors I respect.

The Science of Hitting
The Science of Hitting - 2 years ago    Report SPAM

Thanks for the kind words! In the end, I think we should do just fine :)

Doug Taylor
Doug Taylor premium member - 2 years ago
Thanks SoH, I have been in the same position as you describe. I definitely am not finding much value except in smaller cap stocks so I buy some of them, sell some of my larger caps that have gotten too expensive.

As David Tepper (Trades, Portfolio) says "sometimes the hardest thing is to do nothing".

Great article which is important to all value investors.

The Science of Hitting
The Science of Hitting - 2 years ago    Report SPAM

Great stuff Doug, thanks for the comment!

idaustin
Idaustin - 1 year ago    Report SPAM

Reading between the lines, I'm guessing that you aren't finding any value in Tesla here? (joking of course)

The Science of Hitting
The Science of Hitting - 1 year ago    Report SPAM

Idaustin - It's safe to say I will not be buying TSLA :)

liuherms
Liuherms premium member - 1 year ago

Great article and thanks for the insight. In such a market environment, if you do find a stock that is cheap based on cash flow and asset but is at the high end in terms of historical pb, would you still buy it?. I know value investors say ignore the market, but there's the worry that cheap stock can get cheaper.

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