"The individual investor should act consistently as an investor and not as a speculator."
- Ben Graham
Markets ended the year with a boom. A new President is heading to Washington, regulations are expected to ease, and we could see much needed corporate tax reform in 2017. We view these as positive and we’re not alone.
According to the American Association of Individual Investor Sentiment Survey, just 23.6% of investors felt bullish in the week before the election. Following the vote, the figure jumped to nearly 50% then settled at a still-high reading of 45.6% by year’s end.
Along with driving the indexes to new records, the euphoria led to a rush of cash into equity funds. For the first time in nine months, bond portfolios saw outflows while equity strategies were flooded with more than $58 billion in assets* during the weeks after the election. We’ve long believed stocks were a better bet for capital appreciation in a low rate environment and we welcome the reversal.
But while we share in the enthusiasm caution is required. The meteoric rise for equities has left valuations for many stocks inflated. The value of U.S. common stocks is near historic highs versus gross domestic product, as shown. The upshot is investors are paying more for each dollar of production generated by the nation’s businesses than at almost any period in the last 90 years.
Metrics for the Russell 3000® Index paint a similar picture:
- Price-to-earnings ratios are at 19.0x versus a historical average of 17.7x.**
- The Index trades at 1.8x price-to-sales, above a long-term average of 1.5x.**
These high valuations are particularly alarming given that the money flowing into equities has mostly gone to flavor-of-the-day passive products. Many of these index funds blindly buy stocks based on market cap with no regard to fundamentals. To us, that sounds more like speculating than investing.
In contrast, our work continues to lead us toward cheaper areas of the market where we are finding plenty of opportunities that can boost bottom-line growth and are still at valuations that have the potential to mitigate downside risk.
Navigating between a bright future and an expensive present isn’t easy. It’s necessary to wade through quarterly reports, balance sheets, and meet with management teams to gauge strengths and weaknesses. That’s been our approach over the past three decades and one we think will always be relevant.
Looking forward, we believe most companies will have to navigate some common factors:
- Interest rates could go higher and those with strong balance sheets will have an advantage.
- Inflation may be poised to edge up, meaning companies with unique niches should be better suited to pass along rising costs.
- Current valuations will place a greater emphasis on the need for businesses to grow sales or margins.
We continue to leverage a disciplined process to identify companies that should thrive under the scenarios listed above. Our bottom-up analysis has helped unearth niche companies that have unique product offerings or idiosyncratic drivers and capable management that may help them thrive in the quarters and years ahead. We believe this approach is consistent with Graham’s advice on investing.
Disclosure:
*Investment Company Institute, Long-Term Mutual Fund and Exchange Traded Fund Flows, as of 12/14/2016
**As of 12/29/2016
Past performance does not guarantee future results.
Investing involves risk, including the potential loss of principal. There is no guarantee that any particular investment strategy will be successful. Value investments are subject to the risk that their intrinsic value may not be recognized by the broad market.
The statements and opinions expressed in this article are those of the presenter(s). Any discussion of investments and investment strategies represents the presenter’s views as of the date created and are subject to change without notice. The opinions expressed are for general information only and are not intended to provide specific advice or recommendations for any individual. Any forecasts may not prove to be true. Economic predictions are based on estimates and are subject to change.
Definitions: American Association of Individual Investors (AAII: Investor Sentiment Survey: measures the percentage of individual investors who are bullish, bearish, and neutral on the stock market for the next six months by polling AAII members on a weekly basis. Only one vote per member is accepted in each weekly voting period. Gross Domestic Product (GDP): is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period, though GDP is usually calculated on an annual basis. Passive Management: a style of management associated with mutual and exchange-traded funds (ETF) where a fund's portfolio mirrors a market index. Price/Earnings Ratio: of a stock is calculated by dividing the current price of the stock by its trailing or its forward 12 months’ earnings per share. Price/Sales Ratio: is the stock price divided by the sales per share for the trailing 12-month period. Russell 3000® Index: is a market capitalization weighted equity index maintained by the Russell Investment Group that seeks to be a benchmark of the entire U.S. stock market and encompasses the 3,000 largest U.S.-traded stocks, in which the underlying companies are all incorporated in the U.S. All indices are unmanaged. It is not possible to invest directly in an index.
Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of the Frank Russell Investment Group.
©2017 Heartland Advisors
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