Read any financial website, and you’ll find a common thread among the headlines: The market is overvalued. By several historical measures, the stock market appears to be ahead of itself. Valuations are high, and value-focused investors like Berkshire Hathaway Co-Chairman Charlie Munger are calling for a “lost decade,” one in which gains are non-existent while the underlying companies catch up to their lofty prices.
Ask anyone purchasing lumber these days, and they will tell you that buying something at an all-time high doesn’t feel “great.” It leaves investors wondering if any good investments are left to make, especially if that investor favors value. Let’s clarify some definitions: price is what you pay or sell something, while value is what you believe it is worth. An overpriced investment is when the price is ahead or above its value. Similarly, an underpriced investment is when the price is below what you believe its value is.
That’s why we like to look at it as a market of stocks and not a stock market. Allow me to explain.
With a backdrop of rising inflation, taxes and stock prices, it’s easy to lose the trees through the forest. As a whole, the market might very well be overvalued. But when we look at individual companies, there are always opportunities.
At its foundation, the market is comprised of individual companies, each tackling problems in unique and innovative ways. Hundreds upon thousands of these companies go to work each day to make a better product, service or method. The challenge is in sifting through the pile to find the winners and having the discipline to select them based on their fundamentals and strengths, not on news and hearsay. But this takes work, and work is more challenging than simply investing in an exchange-traded fund (ETF) or buying a mutual fund.
Consider the overall makeup of the S&P 500 index, which is actually 505 capital-weighted companies. In other words, the largest companies have the highest weighting in the index. This means the top five companies have 18.8% of the total index. They are Apple, Microsoft, Amazon, Facebook and Google.
The next five companies represent 7.5% of the index and are Google Class C, Tesla, Berkshire, JP Morgan and Johnson and Johnson. That means more than 26% of the S&P 500 is comprised of just 10 companies. It’s a system that favors making the already big even bigger.
When we evaluate these 10 individual companies, we believe nine of the ten are overpriced. I believe investors “make their money on the buy.” If they can acquire an asset that’s undervalued relative to its price, they will often come out ahead over time. Likewise, you can buy a wonderful company at a high price and end up with a mediocre investment or rate of return. So to us, it doesn’t make much sense to invest in these types of broad market funds where about 25% of the initial investment goes straight into overpriced companies.
We take much greater care in how we invest by seeking companies that are undervalued. We look for companies that are underpriced, as measured by what they earn, trading at less than 15 times earnings. This equates to a 6.6% “earnings yield.” This means if you were to purchase the whole company, you would earn 6-7% on your money from the earnings alone. Add the benefit of dividends and dividend increases, and you get additional rates of return.
Even in today’s highly valued marketplace, there are some great companies out there selling at underpriced values, but they’re boring. They’re not making the headlines on CNBC, they’re not minting millionaires overnight, and they’re certainly not Gamestop.
Instead, they tend to be “every” companies, ones that serve everyone, every day, everywhere. They make items like toothpaste, ketchup and aspirin. Their businesses are not brag-worthy, but their returns and dividend payments over long periods of time certainly can be. Are you investing sensibly or for the latest shiny object?
Saying the stock market is overvalued is an overly simplistic understanding of what comprises the market. That’s like saying the grocery store is overpriced. Sure, meat and seafood have gotten relatively expensive, but bread and vegetables are still affordable. Don’t think of the stock market as a single lump; instead, remember that it is made of individual companies and seek to find those that still represent good value to new investors. Valuation matters; “You make all your money on the buy.” It takes effort to understand the difference between the price and value and wisdom to discern the difference.
An ownership mindset, discipline, a fundamentally sound system, and good investor behavior can put you on the success side of the market.
Steve Booren is the founder of Prosperion Financial Advisors in Greenwood Village. He is the author of “Intelligent Investing: Your Guide to a Growing Retirement Income.” He has been named by Fintech Zoom as a 2021 Best-in-State Wealth Advisor, and a Barron’s 2021 Top Advisor by State. This column is not intended to provide specific investment advice or recommendations.