Twitter Followers may have seen some comments from me recently about how I am feeling that the majority of Stocks are starting to look a bit expensive. This has particularly become the case in recent weeks when I have been plodding through the ‘Company Results’ Section at the back of Investors Chronicle and I am finding a lot of interesting, Quality, Companies but their Valuations look very high and not really the kind of levels I want to be buying at - I would more likely be selling.
I don’t think I am saying that we are about to get a horrific Market Crash, but it could be very dangerous buying Overpriced Stocks and my approach will be to dig deep and try and root out undervalued stuff that has been overlooked - I will go into this more below.
The Valuation Issue
If you have read my various Blogs and stuff, you may know (especially the one called (‘Wheelie’s Daily Roll’) a big part of my Modus Operandi is to trawl slowly through Investors Chronicle, often several weeks after publication, looking for interesting Stocks to buy. If I find something that seems to offer Quality and Growth etc. at a decent Valuation, then I will pop it into my ‘Little Black Book’ (which you can find on the Sister Website, WD2), as a precursor to further in-depth study if I have a Slot and the Cash to buy something new.
However, in the last few weeks, I have struggled to find even a small handful of Stocks that justify entry into the Book - and the common theme is that too much stuff looks ‘Overvalued’.
Now, what do I mean by ‘Overvalued’? In simple terms, I want to buy Stocks that are on P/E Ratios (Share Price divided by Earnings Per Share or Market Capitalisation divided by Profit) of ideally 10 or less but for Quality I might pay up to maybe a P/E of 14 - but it really must be something quite extra special and it must be high growth or perhaps have a Reliable High Dividend Yield or a ‘Special Situation’ like a Takeover possibility or something.
Let me explain why this is so with a couple of examples. Firstly, let’s say you buy a Stock on a Forward P/E of 22 which is forecast to produce Earnings Per Share of 8p, then 10p, then 12p over the next 3 years. This means that with a Forward P/E of 22, it must be on a Share Price of 176p at the moment (8p times 22). With a Share like this, the Share Price will most likely rise with the P/E Multiple - therefore in Year 2, the Share Price will be around 264p (22 times 12p) - because the Market is looking forward to the EPS in Year 3 and is discounting it on a P/E of 22. On this basis, the Upside from buying at 176p in a couple of years is about 50%. (Please note, these are simplistic examples but they should help you understand the Maths behind how Prices can rise). In this example, the Market has fully understood the Story and is pricing the Stock on a High P/E Multiple of 22 - and the Price can grow with the increase in EPS over time.
In Example 2, let’s say that the EPS forecasts are still 8p, then 10p and then 12p, but the Forward P/E when we are considering the Stock is 9. In this case, the Current Share Price will be 72p (note how much lower it is than the Popular Stock in Example 1 at 176p). Now, if the P/E Multiple stays the same at 9 over time, then the Price after Year 2 will be 108p (9 times 12p), and the Upside on the Purchase Price will be 50% - exactly the same as in Example 1.
The Stock is undervalued by the Market on such a low P/E because it has been overlooked or the Market collectively fails to spot a change in the Business or it is not covered by Analysts much or similar - this is the Stuff I want to be buying.
However, there is a twist in the tail (and unusually, it is a very pleasant one) - in reality, as the Company starts to deliver on its growth projections, the Market will start to wake up to the Story and you will find that Buyers start coming in and because the EPS Growth Profile is exactly the same as the Stock in Example 1, the Buyers will be prepared to pay a much higher P/E Multiple - maybe as much as 15 or perhaps nearer the 22 of the Stock in Example 1.
This phenomenon is know as ‘P/E Multiple Expansion’ or more often it is called simply a ‘Re-Rating’, and this is something that I am very keen to capture as the gains can be huge.
To demonstrate this, let’s imagine that in Year 2 for the Stock in Example 2, the P/E expands (re-rates) to 15. In this case, the Share Price will be 180p (15 times 12p), which is 150% Gain on the Buy Price of 72p.
And to stress this further, let’s assume the Stock in Example 2 becomes a ‘Stock Market Darling’ and gets the same Rating as Stock 1 - in this case, the Share Price in Year 2 could be 264p (22 times 12p) - 266% Gain on the Buy Price of 72p !!
From these simple examples, it should be clear why I prefer to find Undervalued Stocks and Low Ratings - the Upside Rewards are far superior and that is how the Big Money is made.
I won’t explain it in detail here, Readers can do the Examples themselves to understand the Phenomenon, but if you have a Stock on a High Rating like 22, if something goes badly wrong and the Stock gets whacked, the P/E Rating works the other way - it CONTRACTS - this is why Shares can fall like a Stone as they Re-Rate in a Very Negative way.
It is extremely important to understand all this about Valuation. P/E Ratios are not something to just ignore and pretend they don’t matter - they do, and they matter immensely. Quite frankly, if you do not understand P/Es in detail then you will struggle to make money consistently in the Markets - the Pros and the Big Institutional Investors etc. fully understand P/E Multiples - and if you watch Dragon’s Den, you will probably realise that those guys are doing P/E Multiples on their scraps of paper while they are considering the Offers they will make to the Latest ‘Entrepreneur’ to enter the Den.
High P/E Ratios (or ‘Multiples’ - same thing) are a sign of Overvaluation in a Lot of Stocks - there are very few Stocks which can maintain a High P/E over time. As such, High Valuations are a Big Risk Factor and it is critical to understand this. As a Share Price rises, its Valuation Risk rises with it - most Investors do not realise this, and often a rising Share Price is seen as Lowering Risks because clearly the Market is agreeing with your View of the Stock. However, it is a an utterly false contention - what is actually happening is that you are swapping Risks - Risks such as Uncertainty around ability to deliver Growth and/or perhaps competence of a New Management Team are being replaced with Valuation Risk.
Of course, a Rising Share Price also means that there is a Positive Risk that helps you - that of Momentum - Stocks with a Strong Uptrend tend to keep going far higher than they should. It is important that we don’t sell out too early and miss this Momentum Bonus - it is a big mistake I have made countless times over the years and I am trying to train myself out of this bad habit.
To avoid this Valuation Risk and to ensure I make Outsized Gains on my Buys - I look for Stocks on P/Es around 8 to maybe 14 or so - if something is extra special, I might cough up 16 - but I would almost never pay higher than this. There is just no point.
Buying Expensive Stocks at the Top of the Market can be extremely fatal - this happened to many naïve Investors in 2007 where they were paying P/E Ratios of 20 and Higher. I will hold Stocks that are on a P/E of 20 to 24 ish if they have strong Momentum and are true Quality Growth with a High Growth Rate - but I will most likely TopSlice the Positions to Bank some Profits and to Reduce Risk (Remember, Risk rises as the Share Price Rises and the P/E Multiple gets stretched).
There is of course a Risk in buying Stocks on Low P/E multiples - it could be that the Market has actually got it exactly right and the Stock is a piece of junk - a ‘Value Trap’. In this case, the Forecasts for EPS are probably wrong and as these Forecasts are missed, the Shares will tank - although you are unlikely to get too much P/E contraction as it is already on a low Rating.
The PEG Ratio
It seems appropriate here to shove in a bit about the mighty PEG Ratio. You may have seen me refer to this before - I think in my Blogs about Sprue Aegis SPRP and Utilitywise UTW it got a good airing.
The PEG Ratio is the P/E Ratio divided by the Annual Growth Rate of the EPS (Earnings Per Share). The best way of understanding it, is that if you have a Stock on a P/E of 15, then it should be growing at 15% per year to represent Reasonable Value. In this case, the PEG Ratio would be 1.0 (P/E 15 divided by 15%) - this would not be especially Cheap but it would not be Expensive either.
However, if the P/E Ratio was 20, but the Yearly EPS Growth was only 8%, the PEG Ratio would be 2.5 (P/E 20 divided by 8%) - this is bad and Expensive.
If the P/E was 20 but the Growth Rate was 45%, the PEG would be 0.44 (P/E 20 divided by 45%) and this would be excellent - in other words, you want to Buy Growth Stocks with a PEG of 1.0 or, ideally, less.
I throw this bit in so that you get the understanding that having a very High P/E is not necessarily a Disaster - if the Growth is there, then it can be justified. However, the important thing to realise is that Growth Rates above 20% consistently year after year are in reality very hard to sustain - it has probably pretty much never been achieved by any Business for more than maybe a few years - and such Businesses will be extremely rare. There may be a few in the Tech Sector that have done this - notably TCM seems to be impressive in this respect.
The reason Growth Rates are hard to sustain, is that Competition increases over time as other Companies see that the high growth Company is doing rather well and they want some of that !! In addition, there is an element of ‘Low Hanging Fruit’ where growth rates can be extremely fast in the early days of a New Market or Product but can get saturated over time as the Customer Base gets satisfied. There are complex other reasons but I will not dwell on them today.
What does this mean for my Strategy?
OK, obviously this means that Care and Thoughtful Decision Making is paramount. As usual, I will be making no Snap Judgements and will be making changes to my Portfolios very slowly. It is never good to Rush Investment Decisions - if you are Rushing or Panicking, you need to step away from the Keyboard and calm down before you make a Silly Snap Decision which will cost you money.
In terms of my existing Portfolios, I am of the general view at the moment that Momentum (‘The Big Mo‘) is still King - this means I am not in a great Rush to sell any Stocks or even to TopChop them - however, I will be Hedging via Short FTSE100 Spreadbets and XUKS ETF if appropriate. I currently have about 20% of my Long Portfolio hedged via Spreadbets.
I fully expect the usual Seasonal Pattern of a Big Market Fall in Autumn to occur this year - so far it has been a Textbook year in terms of how it has played out so I see no reason for us to avoid a Big Drop in September or maybe October - and I am very conscious of this and planning my moves already. As usual, the Market will move first and then the Media will find the Story to fit - this time the Markets will tank and it will be most likely blamed by the ‘Talking Heads’ of CNBC and Bloomberg etc. as being because the Markets expect Interest Rates to rise - or they will find some sort of equally plausible but incorrect reason. It’s actually quite simple - Markets fall because Buyers are less keen to pay up for Stocks and because Sellers are willing to accept lower Prices to dump Stock - it’s all about FEAR and that is remarkably contagious in thin Autumn Markets - I have written a Blog Draft on this but it is for another day !!
I intend to increase my FTSE100 Shorts before September if we get a bit of a Rally in August and/or we get a clear Technical Chart Signal that the FTSE100 is going to tank. So far I have had an Excellent Year with my Main Trading ISA up 21% and I do not want to give away too much of these gains in a Pullback. In the past I have often Sold or Topsliced lots of Shares before Market Drops - but in practice I find it is better to hold on to Great Stocks as they tend to recover very fast after the Market Tanks - so I would rather use FTSE100 Shorts to protect me as much as I can. It is obviously never perfect, but far superior to no hedging at all.
I have a couple of Stocks that I am not overly happy with - particularly FCCN is of concern. I might take action here in coming Days/Weeks.
However, if we do get a significant drop in Sept/Oct (maybe we can see 6000 on the FTSE100), then I will be getting very Greedy and will perhaps even increase my Spreadbet Long Leverage by about 25% to take advantage of what could be a Stonking Buying Opportunity before the usual Big Gains we see in Winter and especially in late December as Santa brings his Sleigh loaded with goodies.
If I can find the Cash, I might be buying a few things for my Income Portfolio - as I already have the full complement of 12 Stocks, I will just be Topping Up some existing Holdings.
Yes, I know I have said that things are looking a bit Overvalued and suchlike, but if we get a decent Pullback in the Autumn, then this Overvaluation will not be so bad and there could be a good Opportunity to buy more of the Undervalued Stocks I hold. Currently, I have many Stocks on Crazy Low P/Es that are the kind of things I would love to buy more of - such stocks as SIV, AVAP, AV., AA., TTR, NPT, EMR etc. all Trade on P/Es below 10 - and they are decent Companies (although NPT needs proper consideration more than the others).
In addition, there are other Stocks which I don’t hold that look very good Value - such as FRP, XLM, ARBB, etc. - so there is Good Value out there but it is becoming harder to find and you need to dig deep and look in the Dark Corners of the Market.
I also hold some ‘Special Situations’ in my Portfolio, where the Stocks might not look so great in P/E terms, but things going on in the Businesses mean they are very undervalued - such Stocks as IOM, ETO (Content Library), AZN (bid?) are good examples.
In terms of Income, some Stocks like GSK, NG., BA., IGG look great value and hopefully will be even cheaper soon.
I am still trying to reduce the holdings in my Main Trading ISA down to 40 (the ‘WD40’) and will be moving in this direction - but I will not be selling Good Stocks just for this reason, I will not rush to get to 40 Stocks but that is the intent eventually. As I mentioned above, Momentum is still powerful in this Market and it would probably be an error to Sell out of almost any Stock at the moment.
Having mentioned that I intend to reduce my number of Holdings, I may Buy a couple of Housebuilders it we get a good Pullback in the Autumn - I sold out of mine way too early, and would like to get back in. PSN is my preferred Pick as the Sector is not as Risk-Free as people think and PSN has the advantages of Size. Housebuilding Stocks tend to go well over the Winter and into Spring.
I will be staying away from ‘Expensive’ Stocks (P/E 18 or more really) as outlined above, but I will continue to hold some on High Ratings if they are Quality Businesses as Momentum could keep driving them up and they may get Earnings Upgrades.
I very much believe in ‘Running Winners’ and will continue to set fairly demanding Target Prices which have a big effect on my willingness to Sell too early as they tend to keep me in a Trade - I find this a very useful discipline. I enter little Text Boxes on my ShareScope Charts for each Stock in my Portfolio - this keeps the Targets clearly in my mind as I look at the Charts every night and I amend them over time.
My Current Views on some Markets / Assets
To add a bit more colour, I thought I would just lay out my opinion on a few things - probably utter nonsense, but maybe worth thinking about:
- High Valuations make me think we might struggle to see the FTSE100 over 7100 this year. I expect a good Rally in December as we usually get one - but we may not see the All Time High taken out. God knows what 2016 will be like, but I know things will be a lot tougher. Interestingly, I am relaxed about Interest Rate Rises - I have read many things about how Stocks are pretty resilient to Rate Rises until they reach maybe 5-6% - that is a long way off.
- Europe is starting to look expensive - so much so, that I am considering halving my Europe Unit Trust Exposure - but I will probably leave that decision to the Year End.
- Japan is a Comedy Country - Abenomics is clearly not delivering and Debt is ever-rising with truly stinking demographics - why anyone has money ‘invested’ here is beyond me. It is probably because all the ‘Experts’ and self-serving Financial Services Industry types are telling everyone to Buy. No thanks.
- DOW and S&P500 look OK on historic norms - however, they are not Cheap in any way and upside may be slow if any.
- Biotech looks Overvalued.
- Tech Stocks in US look very Toppy - perhaps not as bad as Biotech, but there are pockets of silliness. Again, I am mulling over reducing my Exposure to US Tech.
- Bonds are a joke - I hold none and expect the Bubble to go bang soon as Interest Rates slowly start to crawl up (please see my Blog about ‘the Danger in Bond Funds’.)
- Emerging Markets look awful - the BRICs (Brazil, Russia, India, China) all stink except for maybe India - but that could be overvalued. I would not have any money in EMs.
- Gold - hilarious - where are all the GoldBugs now? This is going much lower.
- Commodities - generally awful. Ditching Small Resources Stocks will be shrewd.
- Oil - days of $100 Oil are long gone - I expect subdued Prices maybe around $50 or less for a long time.
It seems to me that perhaps the ‘Easy Money’ in this Bull Market has been had already. Please note that I am not really calling a ‘Top’ here for the Markets - but I do think we need to tread carefully and maybe put in a lot more thought before doing any Buys or Sells - we are probably not at the Top, but we are approaching it. This is no time to be a Hero and crazily Buying in an indiscriminate manner - there is immense Danger in such recklessness.
I think careful sifting through Stocks and ‘Stock Picking’ will become more critical going forwards - buying Overvalued Stocks could really kick you hard.
Above all, remember these are just my current thoughts and I could be wrong on every single thing I have written. However, I have been around the Block a few times and experience tells me to be wary.
Hope I haven’t ruined your Day too much.
Stay Safe, wd