Concentration on Valuation

It doesn’t take long these days, even for the most casual observer of financial press, to hear fears of the stock market becoming overvalued.  Those sounding the alarm would cite a number of factors such as historically high P/E ratios (i) for the major indices, no major market correction in the last two years (defined by a decrease in prices of more than 10%) and the specter of the Federal Reserve Board increasing rates sometime this year.  Their advice would be to allocate away from the embedded danger in the world of equities. 

Although we can’t dispute their observations, we question their relevance.  In our minds it all depends upon how you approach investing and how that meshes with your expectations and objectives.  We happen to believe there is a prudent way forward for investing in equities in this environment.

Averages Can Lie! 

If you put your legs in the oven and your head in the freezer, on average your body temperature would be normal – but we know the reality is far different.  The S&P 500 index currently has an average P/E ratio around 19x’s earnings.  In the context of the index’s historical P/E ratio (around 15.5x) this would suggest that the 500 stocks that comprise that index are currently expensive (ii).

But remember, while the P/E of the S&P 500 is 19x’s, it does not mean that each of the 500 underlying stocks is 19x’s.  The P/E varies based upon each company’s earnings, level of profitability and growth expectations and we know these are not uniform.  Moreover, the S&P 500 P/E is a weighted average based upon market capitalization: it can be overly skewed by the largest capitalization companies (as happened in 1999). 

Valuation Observation

We don’t plan on owning all the stocks in a major index. Nor do we expect to weight our holdings based upon their market capitalization.  So, worrying about the valuation of the “market” seems irrelevant since we are more interested in understanding the business fundamentals of the companies whose stock we own and how they are reflected in its’ individual valuation.

 Nevertheless, using our valuation methodology (focused on normal levels of profitability and growth) we do calculate aggregate valuation statistics for the companies in our valuation screen.  The median price-to-normalized-earnings-per-share (P/NEPS) (iii) for this group currently is 21.0 times – a level consistent with or slightly above levels seen at the 2007 peak.  The middle of the market is pricey. 

The Way Forward

It’s been 75 months since the S&P 500 began its recent bull market move in March of 2009. During this time the index has experienced 12 separate market downturns of at least 5% but all less than 20%. (iv)  The bull market is long of tooth and stocks, in aggregate, trend toward expensive.  What’s an investor to do?

It’s time to be more selective, in our opinion.  While we would not recommend you own the entire market packaged in the form of an index fund or exchange traded fund (ETF), that doesn’t mean you shouldn’t own stocks. You just shouldn’t own every stock. 

In every market environment there are underappreciated companies with goals in place to revive growth and drive their return-on-invested-capital higher.  We believe the opportunity for investors will be to construct concentrated portfolios populated with these companies.  We look for those that are cheap relative to their NEPS and normalized growth rates. The key is to be selective and not reach too far when aggregate valuation statistics are high.

We expect equity prices to be volatile as the US economy transitions to higher interest rates.  If you passively own the entire market via index fund or ETF, you’ve taken no active measure to reduce exposure to these sectors that may be most affected by this volatility.  On the other hand, investing in companies with unappreciated latent earnings power that you know and understand should make it easier to bear the volatility should that long awaited correction materialize.  

As you might expect having read so far, we believe the best strategy for investors going forward is to increase the allocation to a high conviction and concentrated equity portfolio like the Linde Hansen Contrarian Value Strategy.  That is how we believe wealth may be created going forward.  That is how you invest as a contrarian.  

The material provided herein has been provided by Linde Hansen & Co. and is for informational purposes only. Linde Hansen & Co. serves as investment adviser to one or more mutual funds distributed through Northern Lights Distributors, LLC member FINRA/SIPC. Northern Lights Distributors, LLC and Linde Hansen & Co. are not affiliated entities.                                                     5341-NLD-06/01/2015

(i) P/E Ratio is a valuation ratio of a company’s current share price compared to its per-share earnings. 

(ii) Source: Forbes

(iii) Price-to-normalized-earnings-per-share (P/NEPS) is derived from proprietary Linde Hansen & Co. calculations.  It is an estimate of how much a company would be earning today if it were to achieve its historical average return on invested capital.

(iv) Source: BTN Research