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.
