Thursday, December 20, 2012

If You Must Value The Market

I don't engage in market timing. I have been purchasing shares in high quality companies that have a history of paying and raising dividends almost every single month since early 2010. This means I've been sticking to a strategy of valuing individual stocks, rather than trying to value the overall market. I've purchased equities when the Dow Jones Industrial Average has been below 10,000 points and I've also purchased equities when the DJIA has been above 13,000 points, as it is now. I buy monthly because it's a fairly holistic approach to investing, ensuring that I'm not trying to time purchases. I don't let the market really guide me, rather I let individual securities and their pricing guide my purchasing habits.

When I see attractively valued (trading for less than intrinsic value) stocks that have excellent fundamentals that also meet my allocation needs and I have free capital available then I'm likely to buy. This is regardless of whether the DJIA is at 10,000 points or 15,000 points. That's the honest truth. If I was a pure index investor I would probably have greater use for market-wide valuations. But I invest in individual stocks, and as such I try to take advantage of mispricing.

I'm building a Freedom Fund. This is my portfolio of solid dividend growth stocks that will provide me with the income I'll need to sustain myself once I retire at a young age. It's hard to build a portfolio if you're not actively allocating fresh capital to it on a regular basis. I believe in purchasing on a value-oriented basis, using a host of valuation methods like the discounted cash flow model, the dividend discount model, historic price/earnings ratios compared to current the p/e, price/book ratios, price/cash flow ratios, relative pricing to competitive securities in the same industry and the like. What I don't use, for the most part, is market levels to value individual stocks. The stock market is filled with thousands of individual stocks, and many of them will likely be cheaply priced relative to their intrinsic value, and many of them will be priced at a level that is higher than their intrinsic value. While the overall market valuation will tell you if investors are bullish or bearish market-wide, this really tells you very little about individual equities.

I look at the stock market like a giant department store. So, you can take any of your favorites - Macy's, Sears, Dick's for the sporting type. These stores are stocked wall-to-wall with merchandise. Now, you could average out the all the merchandise in the store and cost that out and come up with some sort of average. And, maybe you could say..."wow, that's not bad!" or "hmm, that's expensive." You could make generalizations about all the merchandise in the store as an average, but you'd really be ignoring the fact that the stuff that's located by the front door is probably priced at full-pop and you'd be missing out on the fact that the items located in the back by the clearance section are on sale.

I think of the stock market the same way. There are all kinds of companies out there with common stock that are sold to the public through exchanges - candy companies, shoe manufacturers, companies that sell cigarettes or companies that make construction equipment, aviation corporations and the list goes on. These companies are all priced at different metrics, and at different prices relative to their intrinsic value. Some companies will be currently adored by analysts and investors alike, and because of this their price will demand a premium. Maybe these companies currently in the spotlight just came up with a new product, or beat earnings by a $0.01 (which matters nil in the long run). Some other companies are shunned because they're out of favor due to an earnings miss by an equally minuscule and non-relevant amount, or maybe they're just so boring they're completely under the radar, or the market is trying to anticipate some type of legislation from the FDA or DOD or some other agency about their future and as such is discounting the shares.

So, I don't value the market. I value individual companies based on their intrinsic value and try to buy as far below that number as possible. Sometimes I'm correct in my valuation and sometimes I'm not. Valuing equities, in my experience, is part art and science. You're using exact numbers for formulas and ratios, but trying to anticipate growth rates is a guessing game. The best thing to do is to seek a margin of safety below even conservative estimates.

But, getting back to the title of this article. There are some investors out there that must value the market. They feel compelled to buy "when the market is low", and concentrate on overall market fluctuations rather than the underlying individual equities and their advantageous or disadvantageous pricing relative to value. If this is something that suits you, then I would suggest using two market-wide valuation tools.

The first is inspired by Warren Buffett. I'm currently reading the book "Tap Dancing To Work", a phenomenal collection of articles, speeches and letters by and about Warren Buffett. This compilation was put together by his close friend, and author, Carol Loomis. It's a great read. Warren Buffett doesn't talk about market-wide valuations very often, as he also values common stocks and entire companies by their intrinsic value and tries to buy as far under this number as possible. But, he did engage in a lengthy speech back in 1999 about the state of the stock market and how he felt it was far overvalued. He also spilled the beans on his favorite way to value the stock market as a whole:

Total Market Capitalization As A Percentage Of GNP

What you see in the above picture is a graph showing the last five years of the entire stock market's capitalization as a percentage of GNP. He famously said:

"If the percentage relationship falls to the 70 percent or 80 percent area, buying stocks is likely to work very well for you. If the ratio approaches 200%—as it did in 1999 and a part of 2000—you are playing with fire."

Of course, we all know what happened back then (tech bubble, anyone?). So, Buffett would advocate purchasing stocks close to that 70-80 percent level if possible, and getting up to the 100% level or above starts to tell you the market is fully valued. Going well over that - into the 130% range and above - would tell the average investor that the market is probably overheated and due for a correction.  

You can view this relationship, expressed as a percentage, anytime hereWe're currently at right about 91%. Not cheap, not expensive. 

Another, widely used metric is the Shiller P/E ratio. Robert Shiller, a Yale finance professor, is well known in the finance and economics communities as a relatively rational and intelligent person who tries valiantly to quantify the market's irrationality. He wrote a great book, "Irrational Exuberance", which is a classic tome on behavioral economics and the stock market's volatility. He's just as well known for his Shiller P/E ratio, which uses trailing 10-year earnings, adjusted for inflation. This is known as CAPE (cyclically adjusted PE ratio). 

Shiller PE

The Shiller PE has a median of 15.85 and a mean of of 16.45. We're currently at 21.70. That tells us the stock market is experiencing a bit of euphoria, and probably due for a comedown. You can view the Shiller PE here

If I were to use market-wide valuations as triggers to buy, sell or hold I would use the above two metrics as some of the firmer methods with which to make my determination as to where I think the market is at and where it might be heading.

Both metrics are telling us the market is a little pricey, though to varying degrees. Buffett's total market cap-to-GNP ratio leaves a little room in the tank, while the Shiller P/E tells us the market is fully valued here. That gets back to the part art, part science I was speaking of earlier. There is no definitive tool to automagically tell you where the market is going to be tomorrow, next week, next month or next year. Anything claiming as such is completely false.

Now, don't get me wrong. If the DJIA jumps to 20,000 tomorrow then I'll probably hold off on buying any equities. That's not because some individual equities won't be cheaper than the overall market, but rather because when the market is extremely overvalued it will likely be very difficult to buy any shares in high quality companies below their intrinsic value. However, the market can stay irrational for long, long periods of time. If you face a market that is, in your well-reasoned opinion, expensive and you wait for a better entry could be years or even decades before you find such a point. In the meantime you could have been missing out on rather important time to allow the miracle of miracles.

It should also be noted that as someone who's trying to retire in 10 years, I have limited amounts of time afforded to me with which to allocate fresh capital to attractively valued shares. My buying schedule, at a monthly rate, is therefore aggressive. I suppose someone with an investing horizon of many decades could be a bit more conservative in terms of their purchasing frequency. I still stick to the point I made above about the stock market's relentless irrationality, however. 

Summing it all up, I view valuation as one of the most important considerations an individual investor must face. Buying overpriced securities can lead to sub-par returns over many years. However, I don't necessarily view the overall market's value as the best way to consider valuation on an individual stock because the market is filled with thousands of individual equities all priced differently due to a variety of reasons. You could have a thousand overpriced stocks and a thousand underpriced stocks. But, as someone who concentrates on a rather small subset of stocks, this being dividend growth stocks with long streaks of increasing dividends and strong fundamentals, this limits the universe with which I need to operate in and concentrate my attention. Paying attention to 100 or so stocks and their individual valuations is much easier than trying to pay attention to the valuation of thousands of stocks. 

How about you? Do you value the market or individual stocks? Or both?

Thanks for reading.

This article was written by Dividend Mantra. If you enjoyed this article, please subscribe to my feed [RSS]


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