A return to moderation

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If the past five years are any indication, the stock market is capable of extended periods of overvaluation. These periods of excess lead investors toward speculation, and many jump on the bandwagon.

It is difficult, but when valuations are stretched to the extremes, resist the temptation to join in. Inevitably, the valuations must return to levels that reflect the fundamentals of the underlying business. When the market is priced for such perfection, a little disappointment or change in the macroeconomic environment leads to tremendous contraction in price-to-earnings ratios.

For example, at a 2 percent inflation rate, it is feasible that a stock with a 15 percent growth rate could trade at a P/E of 65x. If inflation ticks up to 2.5 percent, that same 15 percent growth stock would see its P/E nearly cut in half to approximately 35x earnings. Or, should that 15 percent grower slow to 10 percent, the stock will trade at less than 25x earnings.

Last year, the NASDAQ was down nearly 50 percent from the highs it reached in March despite the fact that eight of its 10 biggest daily percentage gains ever occurred that year. Volatility continues at record levels, both on the NASDAQ and the S&P 500.

After 18 years with returns twice the long-term averages, we are likely to experience some lean years. It’s probable that overall returns for the year will be made in just a few days due to high volatility.

In other words, instead of taking weeks or months to realize your return for the year, movements over a few days will equal your total return for the year. Therefore, high net worth investors must stay invested and not time their market purchases.

Back to the basics

Forget about what happened over the past few years. Stock valuations will revert back to the fundamentals of the underlying businesses and the excesses will be eliminated.

In this treacherous market, expect to see a return to value investing that will offer investors superior returns with the least amount of risk.

Due to the pain in the contraction of high P/E stocks, value investing does provide a margin of safety and removes emotion from the investment decision process. For value investors, this margin of safety comes from the earning power of the company and its ability to generate cash flow.

Investors will find that value stocks, for the most part, have low betas (a measure of the market risk in a stock). Low beta stocks do not mean lower returns, just as high beta stocks do not mean higher returns. Instead, value stocks have inherently lower market risk. And, during these times of high volatility, stocks with lower market risk provide an additional margin of safety for investors. Remember, managing money is also managing risk.

Don’t try to time stock market investments. It’s more prudent to price your way into investments. This means being patient and buying a stock when it is a good representation of the fair value for the underlying business. Trying to time a market wrought with excessive volatility is dangerous and usually leads to unfavorable results.

Now, more than ever, it is important to know the businesses you are buying and the value of those businesses. The IPO market has dried up with most dot-com IPOs having gone from riches to rags. The style of momentum investing, where investors chase stocks based on price and pay little attention to the business, has investors reeling from the contraction of valuations in the high fliers.

It is time to get back to the fundamentals of valuing companies based on the quality of earnings and the strength of business. Look for that greater margin of safety to protect yourself from the vicissitudes of the market. It is time for a return to value investing, where the best returns will come to investors who invest with a strong margin of safety. Paul Abbey ([email protected]) is president and founder of The Hickory Group (www.hickorygroup.com), which provides investment advisory services. He can be reached at (216) 781-5600.