Value Investing

Should You Invest When The Market Appears To Be Overvalued?

Charles retired in his mid 50s in May 2016 from a career in Canadian banking. He relies exclusively on income from rental properties and a dividend income stream from a portfolio he amassed over several years.

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u.s market

As I compose this article, the Dow Jones Industrial Average (DJIA) index:

  • is approaching the 25,000 milestone;
  • is up ~2% for the month of December 2017;
  • has experienced 9 straight monthly increases which represents its longest streak of monthly gains in nearly 59 years;
  • is on track to rise more than 25% YTD ;
  • recently notched its 70th record close in 2017.

and the S&P500 index:

  • is up ~1.4% in December 2017;
  • on track for its 9th straight monthly increase which is the longest since April 1983;
  • has posted positive monthly returns, including dividends, for all 11 months of 2017; this could become 12 months if it continues at its torrid pace.

In addition, the market has experienced an extraordinary lack of volatility in 2017. In fact the Cboe Volatility Index (VIX Index), which is a leading measure of market expectations of near-term volatility conveyed by S&P 500 Index (SPX) option prices, is at its lowest level in years.

This has many investors on edge and wondering whether they should invest when the market appears to be overvalued.

In this post I put forth my reasons why investors should tune out the noise and continue to invest despite current market conditions.

This does not mean I advocate investing in anything and everything and at any price. That would just not be prudent! What I suggest is that investors do their homework, remain disciplined, and focus on the long-term goals and objectives they want to achieve from equity investing.

Tune Out the Noise

Sometimes investors can be their own worst enemy. Do you fall in the camp where you must check the value of your equity holdings several times a day? Do you constantly listen to the media which bombards investors with play by play reports on what is happening in the business world?

If you are, I strongly suggest you stop. NOW!

As an investor you should view yourself as a part owner of a business. Business owners do not sell their business on a whim. They invest for the long-term and know that their business will go through various economic cycles.

Warren Buffett and Charlie Munger are arguably two of the world’s most successful investors. When they invest in a business for their personal portfolios or for Berkshire Hathaway, they invest for the long-term. If this strategy works for them it should most certainly work for you.

Readers interested in knowing how these gentlemen invest would be wise to read 107 Profound Warren Buffett Quotes: Learn To Build Wealth. Pay particularly close attention to the section in which 11 long-term investing quotes from Warren Buffett are provided. In none of these quotes will you get any indication that you should jump in and out of a company’s stock.

Your best bet as an investor is to tune out the noise. Identify companies with strong competitive advantages which are priced at attractive or fair values, invest in them for the long-term, and disregard stock price gyrations. If you have trouble leaving your investments alone you may want to get some tips on How to Stop Paying Attention to Your Stocks.

In a nutshell, you want your investment experience to be boring! There are enough other areas in your life where you can seek excitement.

Invest for the Long-Term

I do not foresee a recession on the horizon but I have this nagging suspicion we will experience a market correction of some magnitude. I just don’t know when it will occur and I strongly suspect nobody else does either! In my recent 12 Lessons I Learned From Black Monday article I wrote about how sudden, unexpected, and swift investor sentiment can change.

Based on personal experience and on the teachings of Buffett and Munger I now invest for the long-term. It is for this very reason that I do far more than look at stock screeners when trying to ascertain what companies represent worthwhile long-term investments.

In many cases investors will place heavy reliance on the comparison between a company’s current financial metrics relative to historical metrics. While I do not dispute this is a worthwhile exercise, some investors limit their investment analysis to this comparison.

For example, some investors will look at the current and forward price earnings (PE) ratios and will compare same to the 10 year average PE ratio. In some cases the current and forward PE ratios may be substantially higher than the historical norm. In this case, the typical unsophisticated investor may view the company as being overvalued. Upon performing more thorough due diligence, however, the variance might be the result that the company they are analyzing today is extremely different from the company of yesteryear.

Let me use two examples of why your analysis needs to be far more robust than merely looking at stock screeners.

Had you been looking to invest in Automatic Data Processing, Inc. (ADP) in early 2015 and you were comparing current results with historical results you would have had to take into consideration that ADP spun off two segments of its business into totally independent publicly traded companies. Broadridge Financial Solutions, Inc. (BR) was spun off in 2007 and CDK Global, LLC (CDK) was spun off in 2014.

In our second example, suppose you are entertaining a possible investment in FedEx Corporation (FDX). Unless you look beyond the stock screeners you might think the company is overvalued. If you perform further due diligence you will learn that FDX acquired the European operations of TNT Express in 2015 and that TNT was hit in mid-2017 by a major cyber attack. This has resulted in significant non-recurring expenses as FDX works to fix the damage done and to put itself in a position where an event of this nature will not recur.

This is why you need to look beyond whether the market is overvalued or not. The market didn’t get hit with the cyber attack. FDX’s European operations got hit. It is one-time detrimental company specific events that can present buying opportunities…. These happen whether the overall market appears overvalued or not.

As you can see, if you intend to invest for the long-term it is extremely important that you delve into the details. Equally important, is the need to see where management plans to take the company. Management will typically share their 3 – 5 year objectives, will provide a high level overview on how they intend to achieve those objectives, and will provide periodic updates on how they are performing relative to plan.

When I look to invest in a company I like to use the analogy of driving a car. While driving a car you often look in your rear view and side view mirrors. You, however, spend considerably more time looking out the front windshield. Furthermore, the front window is much larger than the mirrors. This is why you should try to pay considerable attention to where the company is headed and what changes are happening that may positively or negatively impact the company.

Diversify Your Investments

Very few of us can invest like Buffett and Munger, and therefore, adopting their investment strategy of running a highly focused portfolio is unlikely to generate similar results.

Both gentlemen are of the opinion that:

  • you should ‘keep all your eggs in one basket and to watch that basket closely’;
  • ‘diversification is a protection against ignorance. It makes very little sense for those who know what they’re doing.’

The challenge the majority of investors have is that we are not Buffett and Munger. As a result, a prudent level of diversification is more desirable for the majority of investors. This does NOT mean that you should hold small positions in countless companies.

Periodically you will read how an investor will have a relatively small investment portfolio with, say, 75+ holdings. The rationale for this level of diversification is that some investments are overvalued, some are undervalued, some are fairly valued, some will rise in value under certain economic conditions, and others will drop in value or will remain steady.

I recognize it probably does not take much to oversee holdings such as Johnson & Johnson, Microsoft, and other highly rated companies. As a result, an investor would likely need to ‘stay on top’ of some fraction of these 75 companies. Nevertheless, staying abreast of half these companies and their respective industries would be a daunting task.

If an investor is seeking diversification, they would be wise to continually invest in 2 or 3 of the highest quality companies in the five main economic sectors regardless of whether these companies appear to be slightly overvalued:

  1. Manufacturing & Industry
  2. Resources & Commodities
  3. Consumer
  4. Finance
  5. Utilities

Keep investing regularly and you’ll be deploying your money during overvalued, undervalued, or fairly valued market conditions.

If you think about the wisdom shared by Buffett and Munger you begin to truly appreciate that ‘shotgun’ approaches to investing make little sense… especially if you try to spread your regular additional investments over 75+ companies!

If after having pondered over their investment approach you think these gentlemen are ‘out to lunch’ and spreading your investments over multiple companies is the route to go, then you are probably far better off investing in low cost index exchange traded funds (ETFs) versus individual companies.

Dividend Reinvestment

Investors have differing opinions on what is to be done with dividends generated from investment holdings. One camp is of the opinion dividends should be automatically reinvested. Another camp is of the opinion dividends should be received in cash, be accumulated, and then be reinvested in companies deemed to be attractively priced.

Based on my personal investing experiences over the past 30+ years, I suggest the process of automatically reinvesting your dividends unless you are relying on dividend income to cover expenses. This way, you take:

  • advantage of the ‘snowball effect’;
  • your emotions out of the equation. In essence, your money is being put to work regardless of whether the companies in which you have invested are undervalued or overvalued.

By automatically reinvesting your dividends you are truly removing “timing the market’ out of the investment making decision process. Over the long run your dividends will be deployed when the market is overvalued, undervalued, or fairly valued.

Note:  At Sure Dividend, we prefer to accumulate dividends in cash and ‘reinvest’ them back into our best current idea rather than the company that paid the dividend.  In the final analysis, investing in high quality dividend growth stocks for the long run is the main point whereas choosing how to reinvest dividends is a minor point.

Finding Companies in Which to Invest

If you are adamant you want to invest in individual companies as opposed to ETFs and you agree the concept that timing the markets is not prudent then you need to know how to find those reasonably valued companies with strong competitive advantages.

You can certainly find companies that have competitive advantages but if their valuation levels are unreasonable, the odds of creating long-term wealth are stacked against you. Have a look at the long-term stock charts for Intel (INTC) and Cisco (CSCO). Both these companies had competitive advantages in mid-2000. If you had invested in these companies during that timeframe your investment experience would have been highly unpleasant.

The lists of Dividend Kings, Dividend Aristocrats, and Blue Chip Stocks with 100+ year operating histories and dividend yields greater than 3% are great sources from which you can find companies worthy of your hard earned dollar. I do not, however, suggest you limit your search solely to these databases. There are many other wonderful companies that are not included in these lists such as Visa, MasterCard, Broadridge, Honeywell, Canadian National Railway, Union Pacific, FedEx, and Church & Dwight.

Even though some of these companies rarely go on ‘sale’, shareholders who consistently invested in these companies over the past decade have been handsomely rewarded… regardless of whether the market was overvalued.

Final Thoughts

Investing your hard earned money should not be a hobby; hobbies cost money. Focus some time and energy when it comes to investing. This includes doing the following:

  • learn how to read financial statements;
  • actually READ the ‘Notes’ to the financial statements;
  • read the transcripts of quarterly analyst calls;
  • read and listen to investor presentations and presentations made by management at various industry conferences.

This will help you determine whether a company is overvalued, undervalued, or fairly valued. That is what is important…not whether the market is overvalued!

Investors with a long-term investment time horizon and who are prepared to focus exclusively on investing in strong companies with competitive advantages should continue to invest even when the market appears overvalued. The reasons for this are:

  1. The indices are comprised of a basket of companies and not all are worthy of your investment dollar. If you are selective when deciding in which companies to invest, you will avoid investing in sub-standard companies or in companies where the stock price has become detached from the underlying fundamentals.
  2. No investor can consistently accurately predict the direction of the market. Investors who thought the market was over heated in mid-2014, for example, and elected to be underweight North American equities have not benefited from the recent bull market.
  3. You need to view your investment in a company as a ‘business owner’. If you own a business you do not continually buy and sell the business based on general business conditions. You typically own the business for the long haul.

This does not mean you should invest in great companies at any price. You need to properly analyze the:

  • financial aspects of a company
  • industry in which it operates
  • company’s strengths and weaknesses

This way you can determine whether an investment being made during an overvalued market is wise or not.

Thanks for reading this article. Please send any feedback, corrections, or questions to ben@suredividend.com.

Article By Charles Fournier, Sure Dividend