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Are Equities Overvalued?

Are Equities Overvalued?

Guest Post - Monday, February 27, 2017

With the Dow index of 30 stocks recently closing above 20,000, we are getting asked if the stock market is too high. Our favorite answer to this and many other questions is "It depends." Just the price of a stock or the level of a market index doesn't tell the whole story. Part of our answer depends upon whether one is looking at the stock market as value investor or as a growth investor. Both approaches are valid, and both go in and out of favor.

Value Investing

Value investors look for stocks with share prices that don't fully reflect the value of the companies, trading at a discount to their true worth. A stock can have a low valuation for many reasons. The company may be struggling with business challenges such as legal problems, management difficulties, or tough competition. It might be in an industry that is currently out of favor with investors. It may be having difficulty expanding. It may have fallen on hard times. Or it could simply have been oversold or overlooked by other investors.

A value investor believes that eventually the share price will rise to reflect what he or she perceives as the stock's fair value. Value investing takes into account a company's prospects, but is equally focused on whether it's a good buy based on key metrics, like those shown in the table.

Value investing faces two challenges. The first is determining if a company is undervalued for good reason. Value investors typically comb the company's financial reports, looking for clues about the company's management, operations, products, and services. The other challenge is having the patience to wait for that value to be recognized. Value companies often lag in hot markets—like the one we are currently in—but generally do better in sideways or recovering markets.

Growth Investing

Growth investors prefer companies that are growing quickly and that have the greatest potential for appreciation in share price.

A growth investor would give more weight to increases in a stock's sales per share or earnings per share (EPS) than to its P/E ratio, which may be irrelevant for a company that has yet to produce any meaningful profits. However, some growth investors are more sensitive to a stock's valuation and look for what's called "Growth at a Reasonable Price" (GARP). A growth investor's challenge is to avoid overpaying for a stock in anticipation of earnings that eventually prove disappointing.

Value vs. Growth*

Value Stocks Growth Stocks
Relatively low P/E ratio High P/E ratio
Low price-to-book ratio High price-to-book ratio
Relatively slow earnings growth Rapid earnings growth
High dividend yield Low or no dividend yield
Sluggish sales growth Rapid sales growth
Typically, more cyclical companies* Typically, less cyclical companies*

*Note: these are long-term characteristics, not exactly true at any given point in time

Momentum Investing

This style can be applied to either value or growth styles, and it is more closely related to analyzing charts as opposed to company fundamentals. Momentum investors generally look seek out the best performing asset classes and ride the wave of popularity over a recent time period. They often buy when a stock is richly valued, assuming that the stock's price will go even higher. If a stock falls, momentum theory suggests that you sell it quickly to prevent further losses, then buy more of what's working. Easier said than done.

What's the Conclusion?

Pure company statistics aren't enough. A company and its stock price need to be evaluated in the context of the current environment, especially interest rates and inflation prospects. Now, with the new administration, the possibility of negative consequences from deficit spending, tariffs, and trade wars also complicate the outlook, as do the positive possibilities of infrastructure spending, regulatory reform, and tax cuts.

It's a mixed message right now for value investors, since they tend to prefer market bottoms and dire conditions for ideal entry points. We're obviously beyond this point. However, growth and momentum investors might be relying too much on the current trends of market strength, ignoring some of the unintended consequences of policy changes. Based on this perspective, conditions for stocks could continue to be modestly favorable, as long as current earnings, inflation, and interest rate trends continue--and the world doesn't get involved in trade and tariff wars.

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