This lofty valuation is tempered somewhat when interest rates are taken into account. Financial markets are discounting mechanisms. The current value of any asset – a stock, a bond or real estate – is the net present value of all future cash flows discounted back at an appropriate interest rate. Lower discount (or interest) rates are therefore correlated with higher present values (or PE ratios), and vice versa. This mitigates the apparent overvaluation of stocks to a degree but does not make it disappear completely. When the above data is adjusted for interest rates, equity valuations appear much more reasonable, but still not cheap.
A careful consideration of the history of market PEs shows that valuation is a poor timing tool. High PE multiples do not mean that something bad is going to happen, but they do imply that if something bad happens, the market reaction is likely to be magnified. Cheap valuations act as shock absorbers for bad news, but expensive valuations leave little room for error.
To make matters worse, markets do not require a reason to correct, although our innate desire to link cause and effect inspires us to assign one, if only in retrospect. Volatility is an innate characteristic of financial markets. Over the course of this bull market, the S&P 500 has fallen by 5% or more on 22 occasions, averaging a drawdown of 9.9% and a duration of two months. Investors and financial journalists easily and eagerly blamed each of these corrections on some combination of the trade war between the U.S. and China, concern that interest rates were too low or too high, Brexit, political uncertainty, ill-timed White House tweets, fear of an economic slowdown and so forth. And yet, no correction accompanied the recent political showdown over President Trump’s impeachment trial or rising tensions in the Middle East, following the assassination of an Iranian general, or the proliferation of the novel coronavirus. As much as we like our effects to have causes, markets often do not work that way. Volatility is often endogenous.
An old story tells of a young investor approaching a seasoned Wall Street veteran to ask him what, in all of his years of experience and wisdom, he thought stocks would do. “They will fluctuate, young man,” came the thoughtful reply. That this witty response is variously attributed to J. P. Morgan, John D. Rockefeller and Henry Poor (the founder of the eponymous index) speaks to the universality and inevitability of volatility.
How to invest in such an environment?
So, then, what is an investor to do? There are essentially only two investment approaches, although there are practically infinite variations of each. The most common investment approach is price anticipation: an investor tries to figure out what is going to happen in the future and invests based on the anticipated market response to a particular outcome. This is, of course, hard, as the future is always and forever an unknowable place. Knowing this, the investor applies a probability analysis to future events, but usually only takes into account a limited range of possible outcomes. We naturally think of future probabilities in the same terms as flipping a coin or rolling a die, where the range of outcomes is preordained and known. But, inconveniently, the range of outcomes in the real world is not preordained, and it is not known. Roll a die, and the result will be a number between one and six, never a purple unicorn. Life, on the other hand, comes up with purple unicorns far more frequently than one might anticipate. The die of life has infinite sides.
But wait, it gets harder. Not only does a price anticipation approach require an investor to know what is going to happen, she also must know when, as being too early is indistinguishable from being wrong. Finally, even if a forecast and timing are correct, one must furthermore assess how the market will respond to a particular outcome. An investor may accurately predict a strong product launch at a certain company and even anticipate when the benefit of new sales will show up on the bottom line, but if the news is already priced into the market, or if other investors were expecting even stronger sales, the stock price may fall. To successfully employ a price anticipation strategy, you have to be right, at the right time and correctly judge how the price of the asset will respond. Get only two of the three right, and you lose.
Rather than engage in this unsustainable and unrepeatable guessing game, we would rather spend our time and energy learning how to invest in a world of perpetual uncertainty. After all, this is the only environment in which we ever invest. In doing so, we are focused on value recognition rather than price anticipation. This is a far less common type of investment strategy, but more readily repeatable, and, we believe, a better way to pursue the ultimate objective of wealth preservation and growth. If we can successfully identify assets that are trading at less than their fundamental value, then future developments pose less of a risk to portfolios. Of course, no portfolio is immune from macroeconomic or market risk, but investing with a margin of safety helps to mitigate these uncontrollable risks.1
Relying on value is important at any point in the market or economic cycle and is even more important in a market characterized by heightened valuations and volatility. This investment approach is easier said than done, but the key elements of a value recognition approach are as follows:
Invest Actively. Index averages can be misleading, in no small part because company weights in most indices are determined by capitalization. The larger a company is (number of shares outstanding times the market price of those shares), the bigger it is in the index and the more influence it has on the averages. For example, Apple, with a current market capitalization of about $1.4 trillion, has over four times the influence on the index as Walmart, with a market capitalization of only $330 billion. Active investing allows an investor to escape the risk posed by an index that may become heavily exposed to certain companies or sectors over time.
Active investing is not frequent investing. In fact, when done well, it should be the opposite. Studies show that the real benefit of passive investing lies in low turnover: allowing the miracle of compounding to work for your benefit over time without incurring the trading costs, frictional drag and capital gains taxes that accompany a strategy reliant on frequent trading. An active approach combined with low turnover can provide investors with the best of both worlds.
Focus on durability of value, instead of being distracted by the volatility of price. Price is a wonderful concept: it is readily available, constantly updated and consistently agreed upon. The dark lining in this otherwise silver cloud of goodness is that price is volatile, as illustrated earlier in this commentary. Value has the opposite set of characteristics. It is not readily available and requires a great deal of work to obtain. Investors frequently disagree on value. Different analysts can arrive at widely differing opinions on the intrinsic value of an asset, even when they start with the same set of data. On the other hand, value, unlike price, is durable. This one benefit, in our opinion, outweighs all the other, more ephemeral, benefits of price.
Manage risk through concentration rather than diversification. Institutional managers define risk as deviation from a benchmark and manage that risk by diversifying, often to the point that their portfolios look very much like the index. Conversely, managers who define risk in more absolute terms manage this risk through concentration in order to develop and maintain a firm grasp on value. The time and resources required to understand the intrinsic drivers of a company’s value prohibits doing this across a whole index but grants the investor the patience and temperament to invest with conviction throughout a market cycle.
A firm understanding of value allows an investor to invest with a margin of safety. Safety in investing is always and forever a function of price. An investor can lose a lot of money buying a great company at too high a price. Conversely, underpaying allows room for error if fundamental analysis missed something or if unanticipated negative developments arise.
A patient and disciplined focus on value allows an investor to exploit market volatility rather than be victimized by it. The old cliché that one should “buy low and sell high” only focuses on price. Instead, one should buy when market volatility pushes asset prices down to a substantial discount to intrinsic value and sell when upside volatility pushes prices to a premium to intrinsic value. This is a great way to invest over the long term. It just does not fit well on a bumper sticker or t-shirt.