The bull market continues to drag on. The cash balance at most value funds and in many value investors’ portfolios keeps growing. While the rest of the market gorges on the meme stocks, the question on every card carrying value investor’s mind is: where have all the bargain stocks gone?
Let’s back up a little and define what kind of stocks constitute a bargain.
What is a Bargain Stock?
A stock is a bargain when you can buy it for a price that is less than it should trade based on its fundamentals or historical trend. This is similar to the term undervalued stocks, but here we are expanding the definition a bit and including stocks that may not be undervalued today, but could still be a bargain when you consider the cycle of that particular stock or the sector.
For example, consider home building sector. Home building sector is cyclical. There are times when home prices rise significantly as the demand for new housing outpaces the supply of new houses. A home builder in this environment does well as it has the pricing power and can generate high profit margins. At the peak, you may find most home builders enjoying significant profit margins and recent growth. You will also find some home builders whose stock appears to be undervalued when the recent earnings and growth is taken into account or even when compared to the peers in the industry. However, the stock may not be a bargain if you consider the fact that the cycle will top out soon and the conditions are going to become worse for the home builders in the next few years.
A similar thing works in the reverse. When the home building sector is going through its trough, the profits are slim and the stock multiples (p/e ratio or p/s ratio) may be too high. However, if you recognize that the sector is due for a comeback, many of these so called undervalued stocks will do well in the upcycle as they grow their profits rapidly. Some of these stocks are actually bargains, even if they appear to be over valued by most traditional measures.
There are other scenarios where a bargain can be found. One of the most common is to find stocks that are slightly over-valued but the stock price can be supported with consistent dividends and high ebitda. The company may have a sustainable competitive advantage that will help it continue to generate value and grow it for the shareholders over time. Quality, when present, can make a stock a bargain, even if the stock may not be undervalued.
M&A, turnaround and distressed assets can throw up interesting bargains as well if the investor is open to such non-conventional investments.
Why Investing in Cheap Stocks Makes Sense?
Investing in cheap stocks or bargains help reduce the risk for the investor going in.
One of the big risks we have today is the market risk. The stock market is significantly over valued and this level of valuation cannot be supported for too long. The 10 year cyclical adjusted P/E ratio or Shiller P/E today now stands at 37.64. In 2014, Shiller expressed concern that the prevailing CAPE of over 25 was “a level that has been surpassed since 1881 in only three previous periods: the years clustered around 1929, 1999 and 2007. Major market drops followed those peaks”. We are in the historically unprecedented times with stratospheric stock market valuation.
At this time the question is not whether the market will correct soon? The question is when it will happen and how deep the correction will be.
When the market corrects, would you be rather found holding bargains (where the stock price has already bottomed) or would you be part of the herd looking to escape the falling knife in the popular stocks (see herd mentality)?
Personally, I like to sleep well at night. Therefore I want to control for risk. Sometimes controlling for risk means lowering your exposure to the stock market when the market is acting like a casino. You can do this by focusing on bargains or you can do this by removing yourself from the market when the market is insane.
Some other benefits of investing in bargains include:
- You know exactly why you bought a stock. You are not one of those who buy stocks just because every one else seems to be doing it and having fun.
- You know exactly when the reason for you buying this stock no longer exists. When this happens, you have already made your profit and you can sell, or you sell and move on to the next opportunity
- When the market corrects and the herd exits the popular stocks licking their wounds, they will want to park in less risky assets. The bargains that you and I bought will see new influx of capital and we can then take our profits (if it makes sense).
- Making a portfolio of bargains means that our portfolio is less correlated with the market and more correlated with the fundamentals of the business we invested in. It is less exciting, but it will deliver a portfolio that we can rely on in our retirement – alternative is to chase the popular stocks and get our thrills now and reminisce about the good times as you spend your retirement working two jobs.
How to Know When a Stock is a Bargain?
A stock is a bargain if
- It is undervalued based on the financial ratios, and you cannot find any reason to explain the undervaluation. I think this is a very interesting insight. Many people have asked me why a certain stock is selling at such a low price. Sometimes I have an answer, which means that the low price may be justified. Other times I do not have any answer, in which case it is very likely that the low price may not be justified and should be investigated. Here is where you will discount the economic cycle as one of the factors in the apparent undervaluation of the stock.
- If the stock appears to be undervalued, fairly valued or even overvalued, but it is floating in the trough of the economic cycle, and the company is positioned to emerge the cycle stronger than the competitors and possibly gain market share. The business growth will more than justify the current valuation.
- If the stock is fairly or slightly overvalued but the company possesses a moat that will help the company create growing value for the shareholders
- If the stock is fairly valued and pays a growing dividend that you are then able to compound by increasing your ownership consistently
- If the company is undergoing any kind of re-organization or other structural changes and the investors have fled the stock due to uncertainty.
What to do When the Stock Market is Expensive?
This article may have given you some ideas on where to look for bargains in an expensive market. After you have exhausted all the options (cyclical stocks, dividend stocks, m&a and restructuring stocks), you may find that stocks may not be appropriate investments today.
If this is the case, there is no harm in keeping cash. You are not compelled to buy stocks. Many investors fall into this trap. If you have money and you want to invest, be thoughtful about it. I always say that cash has value – it gives you options. And sometimes, cash is a better investment compared to stocks. You could also consider alternative investments until good value stocks become available again.
Finding Value in an Overvalued Market
Continue to research for stocks that you can buy for cheap. Often times it can be a fruitless exercise when the market is highly valued. However, opportunity shows up when you least expect it. You should also investigate dividend stocks as the regular dividend income has a way of reducing risk gradually as your investment gets paid back over time, and you are able to compound your investment over time. Key is to make sure the company is a reliable and growing dividend payer, and you can buy its stock at a fair price.
You could also consider alternative investments outside of the stock market when the market is overvalued.
Generally I have found that great values can be found when you look into the small cap stock asset class. Most of the time these stocks escape investors’ radar and are not really followed by any analyst in a meaningful way. Additionally, these stocks have low liquidity – a classic hallmark of a small cap value stock (liquidity can be used as a proxy for popularity, and you do not want a very popular stock).