'There are always people who say that the rules have changed. But it only looks that way if the time horizon is too short.'
- Warren Buffett
During bull markets, investors often ignore fundamentals like valuation and buy what is popular. This herd-like behavior was evident in many stocks last year.
But the recent pullback in many of these same stocks is a stark reminder of the fact that, over the long run, valuation matters.
If you want to be a successful long term investor,
then you must pay attention to valuation. I will show you why valuation is so vitally important, and how you should think about your next stock investment.
Last year's raging bull market was led by spectacular gains in many 'glamour' stocks - popular stocks with high growth expectations and high valuation multiples. Perhaps some of these gains can be explained by improving fundamentals like earnings, but the driving force most likely behind much of the rise in prices was, ironically, higher prices. This is known as a 'positive feedback loop' and can lead to speculative bubbles.
Recent Nobel Prize winner Robert Shiller has described speculative bubbles as 'a period when investors are attracted to an investment irrationally because rising prices encourage them to expect, at some level of consciousness at least, more price increases. A feedback develops - as people become more and more attracted, there are more and more price increases.'
We saw this behavior in tech stocks in the late 1990s. We saw it with housing prices in the mid 2000s. And we likely saw it at least to some degree among many glamour stocks in 2013.
Shiller himself warned of this in February on CNBC, stating: 'We do have a little bit of bubble thinking... people are very impressed by high tech, probably too impressed... I like to look at long-term earnings.'
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This Time Isn't Different
Back in November 1999, right in the midst of the dot-com hysteria, Warren Buffett wrote in Fortune magazine: 'The inescapable fact is that the value of an asset, whatever its character, cannot over the long term grow faster than its earnings'
Naturally, he was largely ignored or ridiculed at the time.
During periods of irrational exuberance, people will argue passionately that the rules of investing have changed. You'll hear phrases like 'valuations don't matter for this stock because blah, blah, blah' or 'this time is different'.
That may be true for short periods of time, but history shows us time and again that over the long run, valuations indeed matter.
Study after study shows that over the long run, stocks with low valuation multiples outperform stocks with high valuation multiples.
One study by Louis K.C. Chan and Josef Lakonishok in 2004 took a composite of several valuation metrics (price to book value, price to earnings, price to cash flow and price to sales). Portfolios were formed every calendar year-end by sorting stocks into 1 of 10 deciles based on their composite value metrics. The difference in returns between the top decile (glamour) stocks and the bottom decile (deep value) stocks was dramatic, whether it was a small cap or large cap stock.
Another study by Tweedy Browne showed similar results. Their study placed stocks into deciles by P/E ratio and looked at their average annual returns over a five year period. Once again, the higher the valuation multiple was, the lower the returns were.
While glamour stocks can outpace value stocks over short periods of time, history shows that in the end, the tortoise beats the hare - by a long shot.
Good Business, Bad Stock
I'm not advocating only buying stocks with low valuation multiples. Many such stocks are cheap for a good reason. But simply buying a stock just because you expect its earnings or cash flow to grow at a high rate over time isn't enough. You have to buy it at a reasonable price.
As the father of value investing, Benjamin Graham, wrote many decades ago: 'Obvious prospects for physical growth in a business do not translate into obvious profits for investors.'
Keep in mind that in most cases the market has already 'priced in' a company's growth. And if its growth fails to meet (or even sometimes exceed) the market's expectations, then its stock can get pummeled. In other words, a sky-high P/E multiple will eventually contract if a company misses those lofty earnings expectations or when (not if) growth inevitably slows.
Examples like this occur every earnings season.
Investors would be well served to remember that a stock represents an ownership interest in a business. And as John Burr Williams wrote in his 1938 text The Theory of Investment Value: 'The value of any stock, bond or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset.'
Investors often lose sight of this fact during bull markets. The key is to keep your emotions in check and think about a stock as an ownership interest in a business. Pay attention to valuations and don't overpay for expected growth. You want to buy growth at a reasonable price, not growth at any price.
The Bottom Line
During periods of irrational exuberance, many investors lose sight of fundamentals and chase returns. But the key to successful investing is to keep your emotions in check and stay rational. Pay attention to valuations, and when you hear someone shouting 'this time is different', don't believe it.
Where to Find the Best Valuations
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Todd Bunton, CFA is Zacks Growth & Income Strategist. He manages our Income Plus Investor which detects companies that not only pay high dividends but are also likely to see exceptional price appreciation. This is one of the essential portfolios in Zacks Ultimate.
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