I wrote much of the below in past weeks. There is some overlap with the last post but since it was mostly complete I added a few additional comments and posted both today
The Market was at one extreme in March and moving to another extreme today. Much of this can be explained through the lens of a P/E type framework. Simply the Bulls are focused on the P/E Multiple which with interest rates near 0 and corporate credit risk premiums falling due to the Fed, could in theory be astronomical. The Bears are worried about the Earnings which are terrible and still facing huge uncertainties from the virus and trade disputes. The Bulls by nature, are the Growth investors (if you care less about how big the Multiple is, then you must justify it somehow by Growth) which is why tech related stocks have shot through the roof. The investments into bankrupt companies and direct virus victims (airlines, cruise companies) is a little different - I think it's the Fed underwriting credit risk and government covering wages driving this push into high risk assets.
Currently the Bulls are still in charge despite the negative stream of news flow on the real economy and China relations. I don't think the Market is irrational - because Bulls are mainly buying for policy reasons and less for Earnings related reasons (which everyone knows will be poor this year). The Markets fall if a particularly bad piece of Earnings related news appears but I think there's good chance if policy makers come out afterwards giving reassurances on further policy support, it will rally again. The Market usually only focuses on one issue at a time.
Asking if the Market is overvalued today seems the lesser question - the Market is always fair at each point in time given the current set of Investor objectives and desires. The better question would be: is the current Market sustainable? And for how long? Today that seems to depend on when does policy actions change? And under what circumstances, leading or lagging: inflation, financial market confidence, improving virus situation, change in government thinking? I doubt anyone has the predictive powers to know these things even the policy makers themselves.
My job is to find the asymmetric return opportunities balanced with an eye on the risk of permanent impairment in capital. The latter focus means I always think carefully about the sustainability of the current investment environment and the companies I put money in. So while I have continuously increased my equity allocation since March, I have done so on the basis of low to reasonable valuations on sustainable earnings. I have refrained from betting outright on the current Bull market and many of the main Tech and virus victim out-performers.
I won't fight the Fed but at the same time I believe all systems, both Man-made and in Nature, can only be stretched so far before snapping back to a new equilibrium. This makes me believe the massive US policy moves are unsustainable and is building upon many past years of excess. The eventual collapse could be titanic and herald in a new economic order and a new set of market normal conditions. Both the potential magnitude and possible short duration (the US can't sustain the levels of stimulus they've been doing since March) makes me wary today.
My investment playbook is simple: I want to buy companies on cheap to reasonable valuations based on sustainable real earnings/cashflows. The multiple I'm willing to pay depends on their growth profile and ability to return capital. My bread and butter investment companies have one or more of these characteristics:
Wield significant pricing power
Operate in a rational competition environment
Have a strong competitive edge
Strong cashflows
Strong balance sheet
Unrealised upside options (e.g. new revenue streams or cost reductions)
The other basket of investments I partake in are the mean reversion plays. These are based either on Book value or Earnings mean reversion where the Upside should be >2x the Downside. Usually the condition for profit realisation is simple e.g. asset sales, cyclical recovery, survival for a period of time (e.g. recovery of market, or survival of a Supply rationalisation process). Although the risks are higher in some ways, the potential returns are attractive and often have shorter time to full realisation. Sudden industry or macro shocks often throw up baskets of these opportunities. Within a Portfolio there further diversification benefits from holding these.
In all investment cases I'm valuing them as if I was a private buyer looking to buy 100% of the business to hold for a long time. To do this profitably one has to identify a clear measure of intrinsic value and pay a big discount to this value. I feel this method is the best way to protect against the risk of absolute capital loss. Have enough of these holdings and even the biggest Market meltdowns will only temporarily impact an attractive long term rate of returns compounding.
As an example I hold ~15% of my equity portfolio in global tobacco majors. These trade at low teens real earnings multiple and each year return a high single digit dividend yield. Their profits are inflation protected and diversified across the world. Even the virus had little impact on their earnings and their valuations shouldn't be severely impacted by future changes in the risk premium. Now when combined with my China e-commerce/tech, big consumer Brands, Russian champions, low cost energy E&P and Integrated, etc companies the combination is a diversified and resilient Portfolio of attractive Cashflow streams and Assets. I'm confident this Portfolio mix will outperform today's heavily skewed major market cap weighted indices in the long term and in a downturn.
Bring on the next Market Apocalypse!
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