The Current Value Investing Environment

I don't believe I am making a bold statement when I say that the US stock market is not cheap. Even if one takes earnings at face value and uses the bulls optimistic estimates for 2014, multiples are 10%-20% higher than average. If it turns out that artificially low rates have been boosting earnings and that five years into an expansion we may be close to peak earnings than the stock market is expensive.

For value investors whose primary goal is avoiding the loss of capital, the current market environment hardly provides a margin of safety. Of course, the overall market matters less if one is able to find individual securities with a margin of safety. Even in the year 2000, during the biggest stock market bubble in US history, there were bargains as many small cap & "Old Economy" stocks were being discarded in favor of "New Economy" stocks and blue chips. 

Finding bargains in the current market might be even harder than in the year 2000 as small caps trade at record valuations and dispersion in the S&P 500 is at an all time low. The lowest dispersion ever means that the difference between the most and least expensive stocks is smaller than ever. In some sense value investing has become a victim of its own success as "cheaper" stocks have been bid up. The cheapest part of the market, where value investors tend to fish, is as expensive as it has ever been.

What is a value investor to do in such an environment? This makes it much more difficult for a value investor but not impossible. I believe the most important thing is not to force investments or lower ones standards in any environment. If that means holding more cash so be it. 

(As an aside I am actually quite optimistic about my portfolio for the new year, although my positions are largely not traditional value investments (ie. long common stocks). I plan to write about why I'm optimistic about my portfolio some time in the next week.)

If there is anything that I have learned having lived through two bubbles its that expensive can become more expensive. I have also learned that few who say "I will dance until the music stops" find a chair when the music ultimately comes to an abrupt halt. Unless one believes that we are in a new paradigm where cycles have been eradicated than there will be better opportunities some time in the future for value investors. Will you have cash to invest when that happens?


Greg Feirman said...

I agree. Well said.

Tsachy Mishal said...

Thank you. Appreciated.

dis737 said...

I echo your thoughts here, 2014 could be the year where the domestic and global economy finally kick into gear, but ironically, the market doesn't do much to the chagrin of the bulls.

Unknown said...

Thanks for the article.

I found in the 2000 bubble, it was quite easy to find undervalued stocks as much of the market was ignored and the bubble was really in a small subset of the market.

In 2007, it was quite difficult to find undervalued stocks, much worse than 2000, and my notes from that period reflect how I was reducing my criteria to buy stocks, which was a mistake.

In the current market, you can still find undervalued stocks. I would say it is definitely easier than in 2007, but more difficult now than in 2000. If you recall, in 2000, many of the value-oriented fund managers were getting crushed by the market and people like Julian Robertson were even closing their funds. There were many stocks on sale back then.

I think now you have to be selective and also give some upside to company business prospects due to the improving economy. There is a very good chance the market could continue upwards for many years from here and you want to have some reasonable exposure.

Tsachy Mishal said...

Statistically speaking the cheapest decile of the market as well as the overall market is more expensive than 2007.

Unknown said...

That's interesting and somewhat surprising.

I think the differences between now and 2007 are:

1. Recovering economy now vs. mature, real estate bubble economy in 2007. Earnings are much more likely to grow than in 2007, especially in hindsight.

2. In 2007, stocks all around the world were highly valued. Now, it is mainly the US where it is harder to find stocks. Many other countries are well below 2007 in price, some, like Italy, are still 50% below. Even "good" countries like the Netherlands are still below 2007 levels.

Tsachy Mishal said...

There is no obvious catalyst for a downturn like the massive real estate bubble in 2007 but we are 5 years into an economic expansion so one can call this expansion mature as well.

Unknown said...

In 2005 - 2007, you could see the excesses in the economy with the mortgage market, the refinancing offers, the NINJA loans, etc. The hard part was figuring out when it would matter and it took a lot longer to matter than I thought it would.

In the current market, there really doesn't seem to be any excess pressure from the economy overheating, rising commodity prices, inflation rising, interest rates rising (they have come up, but are still low), etc. The only real risk I can see is that something bad happens when the fed unwinds, but I see that as a low probability risk as they can always slow down this process if it causes issues.