September 2019 – Risks and Alternatives to Investing in An Overpriced Index

by Oct 2, 2019Memos0 comments

Stocks should not necessarily be considered risky.  Stocks merely represent the perceived value behind a business.  This perceived value of a company is reflective of the data that is shared about it within the market from annual reports and news outlets.  Businesses can have risk, industries can have risk and the economy can have risk, but stocks do not unless you buy them at the wrong price or hold the stock well beyond what the underlying business is worth.

 Recently, many investors who have applied an automated purchasing process for their favorite growth and dividend stocks are feeling pretty good about themselves.  This process has seemingly worked very well for them in the past 10 years.  This investment strategy’s returns have even surpassed the actual performance of the underlying business operations of these stocks.  But does this mean that the stock’s performance will continue the same path in perpetuity? No.

 This rapid appreciation of the stock prices of blue chips and various other companies that have stable earnings growth can’t continue at the same rate without internal growth dramatically picking up.  When management has exhausted all other forms of adding shareholder value through using tools such as debt, well priced acquisitions and strategic/timely buybacks, there is not much left to boost the value of their stock other than organic growth. Over the long term, a stock’s price can’t appreciate any faster than how quickly their business is growing.  For these reasons, the upside of investing in an index right now is likely more limited to the growth in the company’s earnings. 

 One of the safest investments for anyone to make is paying down their credit card or mortgage.  These investments give you a return as soon as you pay them off.  In almost all market conditions it makes sense to pay off your credit card debt first.   In this case you are avoiding a 19+% interest expense.  It is extremely unlikely that you can consistently surpass this very high hurdle in your investment performance. But depending on your proficiency as an investor and the point of the market cycle, it may make sense to pay down your mortgage depending on the prevailing interest rate you are carrying vs the future potential returns of your investment portfolio.

 In the past 10 years postponing the repayment of mortgage principle has been very advantageous for those who put that money into index funds instead.  The returns in the US indexes have easily surpassed the returns that would have been made from paying down your mortgage and paying the interest.

 But with indexes now trading at historical highs as well as the market not having had a recession in over 12 years, you may feel that a guaranteed 4% return (your mortgage interest rate) might not be that bad of an achievement in the next 4-5 years.  Other options that you can consider to safely guard your money from a reversion in index prices is rotating out of highly valued stocks (with high Price-to-Earnings multiples) to lower valued ones.  

 Small caps as an asset class seem to be a much better environment for finding these opportunities right now. For example, Atlas Mara (LSE: ATMA) trades at a multiple of 5 on their forward earnings and Tandy Leather (NASDAQ: TLF) is trading at a multiple of 5 of their peak earnings in the past 5 years. You can also move your money to more reasonably valued stocks like Berkshire Hathaway which, in some investor’s minds, is as close an individual stock can get to an index.

 While I don’t necessarily endorse or promote these stocks to other investors it shows that the whole market is not trading at 30+ multiples of their cyclically adjusted earnings base and there are pockets of opportunity.   People should not blindly be stockpiling their money away into indexes without considering value at all.  It is important to be more engaged in your financial net worth than that.  If all else fails and you have concerns of where the market is going in the next 5 years, just rid yourself of debt in the ever-rising world of PE multiples.

 When I hear someone state that they only invest in high quality companies, I usually try to persuade them to look at small caps or some less than “desirable” companies as there can be the same opportunity in low quality stocks as there is in high quality stocks.  You can’t just limit yourself to the Amazon’s and Google’s of the world or you are severely handicapping your chances of hitting your investment potential and goals. Every company can be associated with some sort of value and when we reactively rule out investing in a company that we have never heard of or indiscriminately filter out a company that we think is too small to be investable, then you are letting bias enter the very process where it should have no place being.

 There is a universe of stocks out there that do not fall into the growth/blue chip bucket, do not trade regularly or get price quotes daily.  Some of the companies behind these stocks are growing significantly and some are headed towards bankruptcy, but each stock carries an intrinsic value regardless.  Don’t be blinded by the fallacy that one stock is any riskier than another though.  It’s the price you pay for that security in relation to its business’ underlying value that is the risky part.  If you can’t get around this bias and are uncomfortable with the valuation of the market overall, then just put your money down against your mortgage and get better sleep at night.

If you have any suggestions, comments or feedback that you would like to share feel free to email me at alex@StockWriteUps.com.

Enjoy the Journey,

Alex Middleton

Welcome to StockWriteUps.com!

My name is Alex Middleton and I am from Calgary, Alberta.  I believe investing requires one to carefully study publicly available information in an attempt to develop a thesis based on reason and logic.  It also requires one to properly account for the unknown by applying probabilities and margin of safety to their thesis.  I hope you enjoy the content!

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