In the bull market that has been in place since the end of the financial crisis, it is easy to forget the fact stock market cycles tend to be cyclical. Sooner or later, there will be a significant decline and a reversion to the mean for equity valuations. Analysts who proclaim "this time is different" will be proven wrong. Throughout history "this time" has never been different at the top of market cycles.
It is important to remember then that even though stocks might seem expensive today, chances are you will be able to buy them at a much more attractive valuation at some point in the future.
Benjamin Graham, the father of value investing, was well aware of the benefits and drawbacks of market cycles. So he made it clear to his students that there was never any rush to buy securities, as it's more than likely Mr. Market will offer you a better price for the stocks you like at some point in the future:
"When the security market advanced in the last few years to levels which were not unexampled but which were high in relation to past experience, there was a general tendency for security analysts to assume that a new level of values had been established for stock prices which was quite different from those we had previously been accustomed to. It may very well be that individual stocks as a whole are worth more than they used to be. But the thing that doesn't seem to be true is that they are worth so much more than they used to be that past experience -- i.e., past levels and patterns of behavior -- can be discarded.
One way of expressing the principle of continuity in concrete terms would be as follows: When you look at the stock market as a whole, you will find from experience that after it has advanced a good deal it not only goes down -- that is obvious -- but it goes down to levels substantially below earlier high levels. Hence it has always been possible to buy stocks at lower prices than the highest of previous moves, not of the current move."
The above is taken from a transcript of a lecture from the series "Current Problems in Security Analysis," which was presented by Graham at the New York Institute of Finance from September 1946 to February 1947.
Graham goes on to say:
"That means, in short, that the investor who says he does not wish to buy securities at high levels, because they don't appeal to him on a historical basis or on an analytical basis, can point to past experience to warrant the assumption that he will have an opportunity to buy them at lower prices -- not only lower than current high prices, but lower than previous high levels. In sum, therefore, you can take previous high levels, if you wish, as a measure of the danger point in the stock market for investors, and I think you will find that past experience would bear you out using this as a practical guide."
I believe this remains a vital lesson for investors even today. The vast majority of equity returns come from valuation or, to put it another way, the valuation of the stock at the time you enter the position.
If you buy a cheap stock, you are more likely to generate a positive return than if you buy an expensive stock that has to continue to produce a higher rate of earnings growth to justify its valuation. Therefore, it certainly pays to wait before initiating a position.
Even high-quality stocks come under heavy selling pressure during significant market downturns. Take Coca-Cola (KO, Financial), for example. In 2008, the stock dropped from a high of $32 per share at the beginning of the year to a low of $19 in 2009, a level not seen for four years. You would have had to have been very patient to make the most of this opportunity, but the 100% capital gain over the following three years would have been well worth the wait.
So Graham's advice is to wait for the perfect opportunity and, when that opportunity arrives, act with conviction to make the most out of the limited number of home runs that will be available to you over your investment career.
Disclosure: The author owns no stocks mentioned.
