Is the Stock Market Over-Valued? Yes. Should you be worried? Not if you’re under 40.

Pundits have been arguing 3 very disparate views on the market. General consensus is that this year’s stock market returns will not equal last year’s 30% rally. The divergent perspectives are outlined below.

Will skepticism keep a healthy check on bull market overvaluation? This would seem to be a fair point. Bubbles only happen when most investors forget about risk. You cannot argue that we are in a bubble if everyone is yammering about the danger.

Is Buffett right? Are markets back to a fair valuation after years of cheap investment opportunities? Possibly. No one can argue that P/Es are cheap. Several famous value-oriented hedge fund managers -including Seth Klarman- returned money to clients over the past year.

Are markets 50-70% overvalued due to cheap global monetary policies such as the Yellen Put? Will the market stagnate as a result? Monetary policy should be concerning, especially for older investors with lower investment timelines. Stagnant markets can happen. You only have to go back to the 1970s to witness a largely flat decade.

Corporate Profit Margins at Historic Highs

One of the more interesting Bear arguments revolves around corporate profit margins.

Corporate After-Tax Profit as a % of GDP - Bears Love This Chart
Corporate After-Tax Profit as a % of GDP – Bears Love This Chart

Profit margins for U.S. corporations are at historically high levels. Bears think that a mean reversion is in order.

What the Bears fail to factor in is computerization. TI believe the Digital Revolution is a permanent economic upgrade 10 years ago, most of us did not have cell phones. Now we use them to efficiently navigate from point A to point B, to interact with co-workers, to pay our bills.

Perhaps the closest historical comparison we can make is to Great Britain during the Industrial Revolution. I found a very interesting paper detailing the effects of the Industrial Revolution on profit margins. Initially, wages were stagnant, inequality rose, while profit margins doubled. Returns on capital increased in proportion, as new technology investments paid off handsomely. A feedback loop ensued as corporate profits helped to balloon GDP. Sound familiar?

The next 50 years represented a high-water mark of prosperity for the British Empire. Wages eventually caught up, while profit margins stabilized at these new, higher levels after some rather minor mean reversion. Looking at the data from the industrial revolution, it seems clear that corporate profit margins could climb even higher, by as much as 1-6%.

Takeaways

Corporate profit margins, while high, are supported by fundamental improvements in efficiency thanks to the Digital Revolution.

Every market valuation argument has an implicit time-value attached. Hedge and mutual fund managers have to outperform not just every year, but every quarter. Thus market valuation outlooks tend to be skewed to the short-term. This makes some sense if you are trading into and out of companies every week.

However, even in this case we should be basing our estimates on individual stock valuations as well as the scope/scale of opportunity sets. So market valuation really shouldn’t matter much unless you run a macro-driven fund. The scope of opportunity sets has certainly shrunken, but I think there still may be pockets of undervaluation out there.

To anyone not pulling their money out of the market in 10 years, over/under-valuation debates are largely irrelevant. It shouldn’t matter to us what the market is doing in 10 years, or even 20, unless we plan to retire soon. If you ignore market valuation and use dollar-cost-averaging to invest in an ETF or more than 10 individual stock names for the long-term (20-50 years) you can count on the following:

  • Your dividends will compound the money you put in
  • The value of your portfolio will be much larger than the value of your original investment
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Lessons for the Stock Market from Snowboarding

Having just returned from a trip to Vail, Colorado for some beginner snowboarding lessons, I can’t help but make a few comparisons to another interest of mine: investing.

In snowboarding you fall a lot, and it hurts. All it takes is one downslope tumble and suddenly you are on your back with what feels like a keg of TNT exploding inside your skull. Having the wherewithal and grit to hop back up is important. Nobody wants to fall, but you have to go out expecting it to happen, and do what you can to minimize the probability of such occurrences.

Doing what seems contrary often works best. It can be scary to be rocketing down a hill, but losing control of your faculties is the real concern. As you point the board downhill you pick up speed. Your body instinctively leans back onto your back leg, your body thinks that this will slow you down, but that is patently false. All leaning back does is surrender any control you had to the slope, and now you really are in danger. When things seem scariest, your first plan is often the wrong one. What you really should be doing is leaning forward, into the speed, to retain control of your snowboard. This is the only way you can eventually turn the board and slow down, but it also runs contrary to what our body is telling us.

Our instincts are sometimes irrelevant to modern-day situations. The world has changed quite a bit in the last 10,000 years, yet our primal fears have not kept pace. Things like snowboarding and investing did not exist then. Hence what seems mechanically counter-intuitive on an emotional level is the intellectually correct choice.

It does make sense to quit at some point, to pump the brakes and unstrap our feet from the board. The big questions investors should ask are:

  1. How long is our slope?
  2. Where are we?

Most importantly, be prepared to fall and to get back up.

Possible Research Paper – Covered Puts on Deep Value Stocks?

I am wondering if a systematic process of writing deep value puts could be done successfully. We define deep value stocks here as stocks which are undervalued to their intrinsic or tangible book values. Consider the case of Blackberry (NASDAQ:BBRY):

Recently the stock has been selling around $8.25, below the Tangible Book Value(TGBV) of $9.38/share. Interest in covered puts extends all the way down to $4/share, or just 43 cents for one dollar of TGBV. I recently wrote 5 covered puts for December at the $4 price for a sum of $38. Obviously, this is not a lot of money, but I think this might be a viable way to earn interest on my cash with almost no risk.

If Blackberry plunges below $4/share it will almost certainly be worth more. The company is sitting on piles of cash with almost no debt. I would love to get into this stock at such a low price. The company may not be a going concern, but the breakup value will be more than $4.

If Blackberry does not drop below $4/share by December then I will have made a 1.9% return on cash which is basically sitting idle anyway. The strategy matters here a bit. I always try to keep between 5-10% of my portfolio in cash. Lately, it’s been hard to find many good places to put it, and I actually plan to take gains on a few other positions. So if my cash is reserved in case of a major plunge, why not write puts to employ it for a plunge now? The theory is probably sounder than the reality. The problem I have with puts/calls is timing. Writing puts, you only get to buy the stock when the put owner is willing to sell. Blackberry might plunge below $4 in a panic, but it will not stay there. Still, perhaps by splitting purchases between covered puts and limit orders, one could eke out a slightly higher return at very little risk.

Half of my initial planned purchase of Smith & Wesson (NASDAQ:SWHC)is employed in a similar manner. I would love to get into the company under $10/share, and hope that my put holder exercises their right to sell me the shares under $10.

This is definitely something I want to research further.

A Lesson In Setting Low Limit Buy Prices (Thank You High-Frequency Algorithmic Traders) NYSE:GLW

In mid-2012, I began to look hard to Corning Incorporated (NYSE:GLW). The stock was undervalued because of decreased earnings from flat-screen makers. Cash flow was good and management had been doing a great job strengthening the margins. I wanted in, but the stock was trading around $13/share, and I was only willing to get into the company at a conservative price because of its dependence on glass.

I set a limit buy order at $10.79 just in case the stock sank that low, though I was far from sure that it would. I pretty much left it alone for 3 months.

And then Knight Capital Group came along. Knight Capital’s modus operandi was to utilize high-frequency algorithmic trades to make tiny profits on many trades. On August 1st, 2012 an unknown glitch caused their algorithm to go haywire. This triggered a dumping mechanism whereby Knight Capital had an instant fire-sale. One of Knight Capital’s holdings was Corning. My buy order triggered at the very bottom of the sell-off.

Since that fateful day. My GLW holding is up over 30%.

Corning Purchase

Amazingly, a second sell-off occurred in the fall due to a layoff announcement which was overblown. I could have bought in again, but was fearful of throwing good money after bad. Ultimately, the stock rebounded nicely.

I continue to appreciate Corning’s potential. The company maintains strong margins and is working to diversify its revenue streams away from touch-screen glass.Corning continues to innovate new solutions for its clients, large cap companies such as Apple and Google. Corning’s recently announced Willow Glass is going to change the game for mobile electronics yet again.

Cash Flow Financing

I was a bit concerned about the issuance for new debt, but it turns out Corning has done the same thing Apple did. They have been utilizing low-interest rates to finance share buybacks and pay dividends. It is worth noting that Corning has generated positive net cash flows for four years running.

The lesson I learned is stick to your price no matter what the markets do. If there is one thing I can be certain of from my experience as a programmer, it is this: we have not seen the last of algorithmic trading glitches.

Bear Case

  • Company is overly focused on glass screen for revenues
  • Underfunded pension and relationship with unions
  • High R&D Costs
  • Operating cash flow is shrinking

Bull Case

  • Management is controlling costs and maintaining net margins around 20%
  • Progressive dividend policy tied with stock repurchases for the past two years
  • Cash flow supports increased dividends and repurchases

I am confident management will do everything in its power to enhance shareholder value. Wendell Weeks, the Chairman and CEO himself owns approximately $10M worth of common stock and has historically sold shares between the $16-20/share range. GLW is currently around $14.40.

A Long Time Coming

This blog is dedicated to my wife, Janelle. When I met her I did not have enough money to fill my gas tank. Over five years of patient tutelage from her on the subjects of saving, thrift shopping, and common sense the situation has changed some. I may even have learned a thing or two which I can apply to the stock market.

The intent of this blog is to serve as a record of my investment decisions, to better help track portfolio performance and decision-making. Ultimately, the goal of this blog is to help stay me stay in the black. With most of my net worth riding on my decisions, I literally can’t afford to be wrong.

My first experience investing was in 2010, just after my return from Afghanistan. When I deployed overseas, I found myself with not a lot of work to do. Luck played a large part in the next huge turn in my life, when I ran out of everything to read in the hooch, except for financial magazines. I must confess that I had read The Millionaire Next Door and The Richest Man in Babylon prior to this experience, but the stock market was uncharted territory to me. I had saved money for the first time in my life, and had the princely sum of $5000 sitting in a bank account. I knew I should do something with it. I read Fortune and Smart Money, got a Fidelity account, and based most of my initial investment decisions off of the recommendations found there.

Without having read any books on investment, I felt that there must be an opportunity to buy great companies at great discounts. It worked out. Really, investing money in the stock market during 2010 was a “can’t miss” game. Stocks had plummeted so far, so fast, that there was simply no way to lose. Then I read The Intelligent Investor and everything clicked. Finally, a scientific explanation for what I had been witnessing!

The founding principle of this blog is that Mr. Market can sometimes be irrational. I intend to exploit Mr. Market’s brief moments of un-clarity with sizable (3-10% of the total portfolio) purchases and sales. I would love to spread the risk around more but my egg basket is simply not large enough to merit the additional costs in brokerage fees. So I will really have to be on my game with investment choices. Investments will be long. I may write covered puts and calls when I feel the situation warrants.

I do have some advantages over the professionals:

  1. I am in no hurry, and have at least 35 years of work ahead of me before retirement.
  2. Perhaps because of #1 I am not afraid to take chances if the probability of winning out in the long-term is promising.
  3. I have some guiding principles established by the greats who have come before me: Benjamin Graham, Sir John Templeton, Warren Buffett, Peter Lynch, Seth Klarman, David Einhorn and Joel Greenblatt to name a few.
  4. I am currently in my first year at a top-20 business school full-time MBA program. Hopefully I will be learning things which I can apply to my portfolio.

A little bit about my portfolio:

  • 5% Short-term CDs designed to mitigate inflation and force me to wait until next year’s IRA becomes available.
  • 5% Lending Club, this is my first foray into peer-to-peer lending, but the potential returns were simply too good to pass up, and sated my desire to invest in something with annuity-like cash flows, without having to deal with disappointing rates of return.
  • 5% Money Market Funds until I find something I really like.
  • 85% Stocks and Indices – the bulk of my personal savings is invested here. Roughly 10% of this sum is invested in market-tracking indices. The other 90% is composed of individual stock selections.

My investment philosophy continues to develop but I am typically most attracted to, and successful with deep value and distressed equities. I am interested in dabbling in municipal bonds due to all the bad press but do not have the means yet. Some of the stocks which I am currently invested in include: BPDEGACEAIGGEGLWGOOGHBCHMCIBMJPMSAN, and TM.

I am strongly weighted towards the finance industry in particular. Money still crosses borders at incredible rates, and computers are now making it possible for large banks such as JPM to make large-scale position decisions at lightning-fast speeds.

I intend to invest primarily in deep-value and distressed equities. Holding time will vary but could range from 3 months to 30 years. On average, I have owned the stocks in my portfolio for 2 years, and that average will probably get longer. I am a long-term investor, and simply am unwilling and unable to attempt to predict the timing for an individual stock’s decline. Market timing is nearly impossible and ultimately, probably not worth the effort for me. I may invest in bonds or esoteric ETFs on an experimental basis, but do not intend to put large portions of my own retirement into products which are still in beta-testing (pun not intended).

I am not afraid to invest in “growth” stocks if I believe the cash flow exists to support such investments but, by and large, I tend to avoid anything with a P/E over 25, or bloated Price/Tangible Book Value ratios.

I will focus future posts on specific investment recommendations. I do not have a bottle of champagne to break over my laptop, and thereby christen this new endeavor, but rest assured, I did chug a beer and crush the can.