Valuations High? Stick To Cash, Foreign Companies, Value

What to do when Valuations are High? By David Merkel, CFA of AlephBlog

A letter from a reader:

Hi David,

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What would you recommend for a long only equities portfolio?

I too think the market may be overheating, but as always, it’s impossible to tell when the party will end. I would have said the same thing last year this time as well.

This is what I am doing now:

  1. Cash is presently 16% of my portfolio.  I let that fluctuate between 0-20%.  I try to be fully invested during crises, and build up some cash when valuations are extended.  16% means valuations are high, but they could get higher — we aren’t at nosebleed levels.
  2. I have more invested in foreign companies than I normally do.  Around 40% of the portfolio is in foreign companies, which are at present undervalued relative to similar US companies.
  3. Emphasize companies with strong balance sheets, in industries that will not go away.
  4. I own cheap stocks.  The median valuation of the stocks that I own is around 10x earnings, and 1x Net Worth (Book Value).

This isn’t sexy, and if the market roars ahead, my clients and I will underperform.  But if there is a reason that emerges that causes the market to fall, my clients and I will do better than most.

I take more risk when the market is in the tank, and less when everyone thinks things are great.  This is particularly true when policymakers like the Fed are triumphant over high valuations, and low yield spreads.

This is a time to take less risk, in my opinion, but not a time to take no risk.

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.