Thursday, October 3, 2013

Warren Buffett Isn't Excited About Buying Stocks Right Now, Should You Be?

In a recent interview with CNBC, Warren Buffett advised that he's having a hard time finding any bargains around. He believes stocks right now are "more or less fairly priced" after a significant run that started back in early 2009. With the stock market at all-time highs, I'm inclined to agree with Buffett.

While I refrain from valuing the market as a whole because I'm not an index investor but rather an investor who purchases shares in individual businesses, an expensive market is unfortunately generally filled with expensive stocks. But there's always a value or two that an enterprising investor can focus on, if one looks hard enough. You can go to Saks Fifth Avenue and speculate on the how overpriced the entire store is because it's mostly filled with expensive merchandise, but you'll still likely find a cheap shirt or two on one of the clearance racks in the back.

And that's really what us value investors try and do: find a sale in the midst of otherwise expensive merchandise. Obviously, right now that's pretty difficult seeing as how a rising tide lifts all ships and the market's tide has been on a relentless push upward for over four years now. Where bargains were easy to find when I first started investing back in early 2010, they are now quite difficult to come by. For perspective, the S&P 500 is up over 130% since the lows of March, 2009. 

Taking a look at the cyclically adjusted Shiller P/E Ratio, we can see it's currently at 24.45. That's rather high, and potentially portends a pullback in the broader market, and with it most stocks within the market. As always, caution is warranted when we see anything at all-time highs. While Jeremy Siegel, the well-known Professor of Finance at the Wharton School of the University of Pennsylvania, has recently taken issue with the Shiller P/E Ratio, no matter how you slice it long-term investors would be wise to be extra cautious about how much they're paying for assets today.

They more you pay today, the smaller your future returns will be. Furthermore, the more you pay the less shares you'll receive for the same amount of money, and therefore the less dividend income you'll receive from your initial investment which can then be reinvested back into your holdings buying even more assets. Obviously, it pays dividends both literally and figuratively to be aware that price and value are quite different.

If stocks are expensive, what do asset accumulators do right now? Well, usually it would make sense to focus on other asset classes when stocks themselves are generally expensive. However, this might not make a lot of sense right now. Gold produces no income and I'm of the opinion that it's a horrible investment. Real estate, like stocks, has largely rebounded after the burst of the housing bubble that preceded the Great Recession. So, it might be tough to find undervalued real estate right now. In addition, buying and selling real estate takes great confidence in one's knowledge of a local market and is usually much more capital-intensive than investing in stocks, all while having higher friction costs in the form of commission fees. You also have leverage involved and greater risk due to exposure to a more concentrated asset base. Of course, you could also buy rental houses and turn your real estate investments into income-producing assets, but being a landlord is certainly more hands-on than stocks and definitely not for everyone.

Bonds are also pretty tough right now. The yields are historically low after a huge bull run in bonds over the last 30 years or so, and the face value on today's bonds are likely to only decrease over the long haul. Even if you hold to maturity, you're exposing yourself to historically low yields. Then there's cash. Of course, cash produces no long-term returns and instead will only decline in value due to the ravages of inflation. On the other hand, it may make sense to build up cash when most other assets are overpriced as this provides an individual investor the flexibility needed to pounce on opportunities when they become ripe. If you're busy buying overpriced assets and the market corrects to a mean and you have no cash with which to buy now fairer priced securities, you're putting yourself at risk. 

I'm following the latter strategy right now: building up cash. While I still believe in purchasing high quality dividend growth stocks on a monthly basis so that I can build up an ever larger passive income stream with which to reinvest and compound my gains, I also believe in not overpaying even for high quality. And right now, high quality is generally expensive. Most high quality companies that have long track records of raising dividends are generally selling close to 20 times earnings, and some even higher. Examples include Johnson & Johnson (JNJ) at 20 times earnings and The Coca-Cola Company (KO)at 21 times earnings.

Total returns for investors come from advancing share prices and dividends received. The share price increases come from larger earnings assuming a static valuation, or P/E expansion when purchasing undervalued securities. I'm simplifying it a bit there, but that's generally how it works. Obviously, it's difficult to assume much from the latter so you're largely looking at earnings growth alone to increase share prices for most companies right now. I prefer a margin of safety so that even if I'm wrong and earnings are flat, I'm receiving a good yield from my investment so that I can reinvest back into an undervalued security thereby compounding at a rather effective rate. It's tough to do this when you're paying a premium.

I've been rather inactive this month, only adding to my position in Realty Income Corp. (O) on what I felt was areasonably attractive price on a long-term basis. And scanning my portfolio and the market for further opportunities, I feel like I'm in the same boat as Warren Buffett. I'm not particularly excited about anything I see, and I'm having a hard time finding anything to purchase.

Looking at individual opportunities, I felt Philip Morris International (PM) was attractively priced in the low $80's just earlier this month, but after a dividend increase and investors apparently also noticing the value PM has jumped over 7% and is now priced above $90 per share. I passed up what I felt was an opportunity only because PM is already my largest position and I didn't feel very comfortable allocating more capital to the company here. I currently think Kinder Morgan Inc. (KMI) is attractively priced for the long haul at just over $36 per share. The shares have taken a hit after hedge fund Hedgeye has alleged that the firm is not spending enough on maintenance and the share prices on all of the Kinder Morgan investments are overpriced. I disagree and if I wasn't already also heavily allocated to KMI I would be adding at today's prices. With a yield of 4.42% and heavy growth on the back of the Incentive Distribution Rights (IDR) payments investors stand to do well here. I also think Exxon Mobil Corporation (XOM) and Wal-Mart Stores, Inc. (WMT) offer reasonable value. 

In conclusion, Buffett isn't excited about buying stocks at today's prices. And I'm not either. While I'll continue to selectively purchase equities that make sense on a valuation basis while also making sure I'm not over-allocating to any one position, I'll also keep these selective purchases smaller than usual as I build up my cash position waiting for cheaper stocks that offer larger margins of safety, and hence higher yields and more attractive long-term returns. 

How about you? Excited about buying stocks right now?

Full Disclosure: Long JNJ, KO, O, PM, KMI, WMT

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


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