“Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.” – Warren Buffett
The stock market is making new all-time highs once again. So naturally, more and more amateur investors are piling in.
According to a recent article in the Wall Street Journal (subscription required), discount brokerages are seeing record daily trading volumes, and investors are borrowing more money than ever to buy stocks. Margin debt hit an all-time in December of $444.93 billion, which was up 35% year-over-year.
Historically speaking, soaring margin debt has provided a warning signal that a bull market is nearing its end. Take a look at this chart from Seeking Alpha:
This Time Isn’t Different
“There are always people who say that the rules have changed. But it only looks that way, if the time horizon is too short.” – Warren Buffett
Equity investors are certainly feeling more confident these days. While it’s difficult to say whether or not the market as a whole is overvalued at this stage, there is certainly a bit of “irrational exuberance” among investors in some individual stocks.
That’s because investors often forget this simple axiom during raging bull markets: valuation matters.
Not Just Pieces of Paper
“The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.” – John Burr Williams
Let’s think about what a stock is for a minute: it is a share in the ownership of a company. So as a shareholder, you’re really a part owner in a business. And whether it is a lemonade stand or a multinational conglomerate, the intrinsic value of that business is the present value of its future cash flows.
Granted, forecasting cash flows for almost any business is difficult and often fraught with error. However, decent proxies for discounted cash flow analysis are valuation multiples on earnings and cash flow. Study after study has shown that stocks with low price/earnings or low price/cash flow ratios have outperformed the market. Meanwhile, those with high P/E or P/CF multiples have underperformed.
Good Business, Bad Stock
“Obvious prospects for physical growth in a business do not translate into obvious profits for investors.” – Benjamin Graham
Simply buying a stock just because you expect its cash flow to grow at a high rate over time isn’t enough. You have to buy it at a reasonable price.
Keep in mind that in most cases the market has already “priced in” a company’s growth. And if its growth fails to meet (or even sometimes exceed) the market’s expectations, then its stock can get pummelled. In other words, a sky-high P/E multiple will eventually contract if a company misses those lofty earnings expectations or when (not if) growth inevitably slows.
Examples like this occur every earnings season.