Fighting the Wrong Battle...

Is the market too high?

Is the stock market too high?

Given how much the U.S. stock market has run up over the last five years, you hear a lot of talk these days about how the market is expensive and too high based on historical P/E or some similar metric.

I think if you buy individual stocks, discussions about “the market” are pointless.

The stock market is a collection of very diverse assets – from Google to Halliburton, to biotech startups, to community banks. And it is very large – by my count there are over 25,000 public companies in the world with a market cap of $25 million or more, with over 4,000 of them located in the U.S. Yet all of these companies get lumped together in “the market”. Maybe if you are an economist or a huge mutual fund it is interesting to look at things from this very broad perspective, but as an individual investor that only owns a few stocks, your assets are probably concentrated in less than 1% (or even less than 0.1%) of securities. In this case, the valuation of the average stock is not meaningful. What is interesting is the dispersion of valuations.

Consider if the S&P 500 consisted of 495 stocks that traded at a P/E of 100x and 5 stocks that traded at a P/E of 2x. The market would be insanely expensive! But the individual would still have fantastic opportunities, assuming you could concentrate your portfolio in the 1% of companies with very low valuations.

So what is the dispersion of valuations in the market like today?

I made the following chart using Capital IQ. It shows the number of U.S. companies (minimum market cap $25 million) trading at very low multiples  at any given time (I use less than 2/3 of tangible book value. Why book value? No particular reason, but book values tend to be more stable than earnings, so I thought this might produce more intuitive results than an earnings multiple).

I think the chart is interesting. As you would expect, it shows an explosion in the number of cheap stocks during late 2008 and 2009. And it shows a decline in the number of cheap stocks since then, again as you would expect.

But what surprises me is that is also shows the number of cheap stocks today is actually still much higher than during the entire 2003 to 2007 time period. I don’t think many people would say that the US stock market was significantly overvalued at the end of 2003, and today there almost twice as many cheap companies as there were then.

Now I’m not saying that companies that trade at cheap multiples of book value are necessarily good investments. A lot of them are probably overstating the value of their assets, or are overleveraged, fraudulent, have terrible prospects, etc. But I think a low price is always a good starting point for looking for bargains. With over 70 such companies today I would guess at least a couple of them represent undervalued investment opportunities.

So I think that when you hear people today complaining about the lack of bargains in the market, or stocks getting too high, I think that is certainly true relative to the past few years, but to a large degree this reflects more of a return to normal, compared to the extraordinary period from which we have recently emerged. If you are a smaller investor who concentrated your holdings, I think there are still a good amount of opportunities today.