To me, there’s almost nothing better than finding a great company that I truly want to own at a fair valuation, or better yet, undervalued. In the long run, it has been my experience that this usually leads to outsized future returns, especially if you buy stocks when they are undervalued at the time. But there is quite often a side effect that can prove very disconcerting. Once an undervalued stock starts moving to the upside, momentum will often carry it above what prudent fair valuation would dictate.
In his book, The Dhandho Investor: The Low–Risk Value Method to High Returns, Mohnish Pabrai coined an investment approach known as "Heads I win; Tails I don't lose much." Q3 2021 hedge fund letters, conferences and more The principle behind this approach was relatively simple. Pabrai explained that he was only looking for securities with Read More
As a result of the recent run-up in the market, many of my holdings have, by the strictest of definitions, become overvalued. This begs the general question: what do I do now? Moreover, additional questions pop up such as: If I do sell, should I sell a part of my position, or all of it? When should I pull the trigger, or put another way, how much overvaluation (risk) should I accept before I sell? Since the market is overheated, should I go to cash or look for alternative investments at better valuations to invest in?
Answering these and other important questions correctly could have a major impact on my financial future. Therefore, prudence dictates that I must take great care to think things through to their logical conclusions. However, experience has taught me that there is no general, or one-size-fits-all, answer to any of these important questions. The only way to truly get these questions right, is to analyze each specific company (stock) that I own one at a time, basing my decision on the individual merits of each.
On the other hand, there are general principles that should always be kept at the forefront of your mind when attempting to make sound and proper decisions about overvaluation, or any investing decisions for that matter. A few of the more important ones can be gleaned from following or adhering to the lessons of master investors like Warren Buffett or Charlie Munger. For example, these legends of investing have shared the following principles that they believe in, and that apply to sound investing, and I believe are appropriate to this article’s subject matter:
“Inactivity strikes us as intelligent behavior.” Warren Buffett, 1996 Berkshire Hathaway Annual Report
“Investing in a market where people believe in efficiency is like playing bridge with someone who has been told it doesn’t do any good to look at the cards.” Warren Buffett
“If you aren’t willing to own a stock for ten years don’t even think about owning it for ten minutes” Warren Buffett, 1996 Berkshire Hathaway Annual Report
“Investment students need only two well taught courses: – How to Value a Business, and – How to think about market prices” Warren Buffett, 1996 Berkshire Hathaway Annual Report
Consequently, I suggest that it is wise counsel to keep the principles underpinning the above quotes in mind when contemplating buy, sell or hold decisions based on overvaluation. Additionally, I believe these principles provide wise counsel no matter what type of investing decision is being contemplated.
Moreover, there are several challenges making it difficult to correctly answer the question cited above. First and foremost, you must, within a reasonable degree of accuracy, accomplish the task of correctly ascertaining fair valuation. How could you expect to know if your stock is overvalued if you do not know what fair value is? Common sense and a historical precedent can be of great value in computing fair valuation. But, most importantly, an accurate as possible forecast of the future will be your best gauge.
There is also the dilemma created by a market whose nature is often one of temporarily behaving irrationally. In other words, a stock can become overvalued, stay there for a long time, and often continue advancing far beyond what any rational computation would justify. Therefore, at the end of the day, all one can do is run the numbers out to their logical conclusions, and make their best judgments based on those calculations. The point being, investors should understand that there is no perfect answer to any of these questions, only reasonable ones. However, it has been my experience that reasonable answers generally pan out in the long run, but they do not always provide instant gratification over the short run.
How I Plan To Specifically Deal With The Many Faces Of Overvaluation In My Portfolio
The great recession of 2008, in addition to the pain and suffering it caused, also brought a great opportunity. In perhaps the greatest self-help book ever written, Think and Grow Rich, author Napoleon Hill offered up an extremely important piece of general wisdom as follows: “in every adversity lies the seed of a greater or equivalent benefit.” The great recession of 2008 was no exception to Napoleon Hill’s axiom. As a result of the massive selloff in stock prices, good and bad stocks alike saw their valuations decimated. When this occurred, I continued to avoid what I considered the bad stocks as I always had, but rejoiced in the opportunity to purchase good stocks on sale.
However, as I alluded to earlier, a side