Quality vs. Valuation

[EricL]

Thought this was an nice comment from SeeksQuality on Seeking Alpha this morning on his thought process on paying a premium for quality vs. buying "value" stocks.

It is true that there are often real reasons why a company is trading at a premium valuation. But conversely, there are also often real reasons why a company might be trading at a discount valuation. The key pitfall for a value investor is a "value trap", in which a weak company is trading at a discount -- yet weak performance continues to pull the stock down. This often leads to a dividend cut and selling at a steep loss.

Does it make sense to sell a strong company at a premium valuation to buy a less-strong company at a moderate valuation? Does it make sense to buy a weak company at a discount valuation? Perhaps! The market tends to overreact to both strength and weakness, so trades like this can often allow the investor to profit from a "correction" period. I did that with ORCL earlier this year, reaping a 15%+ gain in one month as the valuation corrected. But trades like this weaken the operating performance of your portfolio. If you want to own strength, you need to swap back into the stronger company as soon as the correction period is over. Longer term, I want to own MSFT in this space.

The most impressive results are when you can buy strength at a discount valuation. AAPL in 2016. SPG a year ago. It can be a little scary to look past the FUD of the market correction to see the strength, but if you can manage that then you do very well.

Yet there are also times when TRYING to do this hasn't worked out so well for me. Back in 2011, I knew that HPQ was a solid company with a wide moat. Their printer-ink business alone justified the price of the company, and they had a couple other profitable franchises as well. How can you go wrong buying a great company like that as a discount?!? I dunno, but I somehow managed to lose $4k in 2011 and as if that weren't enough I came back to lose another $2.5k in 2012. Value Trap!

Thus I've come to the conclusion that the best opportunities are buying strong companies at valuations that are near or even above the market average. Nike in 2016. MSFT in 2017/2018. Perhaps AMZN today (though the multiples on that one are still VERY high)? None of these traded at a discount -- but the operational performance and subsequent price strength more than justified those purchases.

Nothing against paying less for a purchase, but the most important thing for me at this time is to buy strength. If I can buy strength at "fair value" or even at a modest premium to FV, then that works out very well for me! If the price drops further, I will happily add more. At this point in my investing journey, I don't want to be gambling large sums on discounted weakness.

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I've had many more losing trades when buying value stocks than when buying best of breed at premium valuations. Some of my worst sales were when I trimmed or sold great stocks that I thought were overvalued to free up funds for cheap stocks that I thought looked like better values.

When investing for the long-term it's better to just buy the best companies and hold them forever rather than waiting for a perfect price to do it or buying lesser companies just because they are cheaper.

[fenders53]

I will torment with this forever. Buying quality has worked out better as long as I paid some attention to valuation. I do not believe you win in the end if you pay no mind to valuation, no matter how good the company.

My smartest buys ever were CSCO-INTC-MSFT-PFE in the mid 90s.

My stupidest holds ever were CSCO-INTC-MSFT-PFE about 5 years later. Stupid is harsh so I'll upgrade myself to ignorant but a value investor did warn me. Reckless was rewarded for years so I was wiser than he until I wasn't.

Nortel-Lucent and Motorola were dominant when I started investing. They all pretty much went BK while the value stocks lived on. The widely held price targets on QCOM over 20 yrs ago was $800-1200. Are we there yet? Nope, TSLA has replaced it with a $4K price target.

Value traps will always be value traps. Trash is priced like trash maybe because it is trash? I've made money on MO and T only because I was lucky and didn't buy them 5 years ago. I lost money on XOM because I wasn't lucky. The high yield is well celebrated here while they underperform SPY by a VERY WIDE margin for at least five years. We happen to be up so they are great stocks. I play the game but I try not to fool myself.

If I even have a point it's this is a marathon and our decisions are GREATLY influenced by recency bias and the sometimes random timing of our investments.. Five year charts don't impress me much unless the underlying fundamentals somewhat validate the share price. 90% of the past five years were bull market months.

Valuation WILL matter in the end, but it's not just a matter of looking at next years PE. We'd all own our personal island if it were that simple. This is probably the most heart felt post you will ever get from me on this forum. I am convinced my views are valid. The market does not follow our simple rules for years at a time. The only thing I believe I have figured out in 35 years is how to not get my port killed due to fear, greed and arrogance. I wish I was 25 again.

[Dividendwayfarer]

It is challenging to pick between overvalued quality stock or undervalued ok-quality stock. I used to buy stocks with a PE under 20 only and I lost many growth opportunities and find myself hold many failing cheap stocks.

I now pay less attention to PE and try to find a good stock of peg under 2. It should also have a good dividend track record and ideally the currently yield is higher/close to the average yield.

[fenders53]

I pay attention to PEG as well and 2.0 used to be "overvalued". Many of the great stocks have far exceeded that for years. AMZN did not have a reasonable PEG until over half the run was over. Discounted future cash flow models are probably best as financing got more creative. AAPL has been printing money with less than mediocre growth rates for years. Balance sheets and other things matter too. This is never going to be easy.

[crimsonghost747]

The thing that really skews this viewpoint is the fact that we are in a bull market that has lasted for the past 13 years. The more growthy things you have bought, the better it has worked for you. And this has quite literally gone on for so long that the majority of investors, myself included, have never witnessed anything other than a strong bull market. The story will be very different when (if??) we see a bear market again. Times change, this market surely isn't anything like what we have seen before. Any sign of a downward turn leads the central banks to just pump more money into the market.

That may sound like an exaggeration, but just a week ago Jerome Powell said that they want to start lowering FED purchases before the end of the year and the market fell a couple of %. Today he said that they aren't in a hurry with it and that they don't want to do anything too fast. Absolutely zero has changed in the economy since last week, the guy is just a talking head saying what people want him to say. And by proxy, the FED policy seems to be what the people want it to be. We could be heading into another 13 years of central bank powered bull market. And yes, then growth will be where the money will be made.

Quality is always the most important thing for a long-term buy and hold. And paying ridiculous valuations works extremely well as long as the music keeps playing. But in the end I think it's that it's more about finding the right balance between risk and reward (growth and value) which fits everyone's individual preference.

[fenders53]

(08-27-2021, 01:52 PM)crimsonghost747 Wrote: The thing that really skews this viewpoint is the fact that we are in a bull market that has lasted for the past 13 years. The more growthy things you have bought, the better it has worked for you. And this has quite literally gone on for so long that the majority of investors, myself included, have never witnessed anything other than a strong bull market.....

But in the end I think it's that it's more about finding the right balance between risk and reward (growth and value) which fits everyone's individual preference.

That is exactly what is going on.  It's recency bias.  I don't think we disagree on much.  The article basically states valuation doesn't matter, good stonks go up.  The problem is mediocre stocks go up too.  Some stocks that haven't really grown since 2019 go up.  Most of the weakest Aristocrats trade at valuations only the best ones commanded 5years ago.  Everybody knows stonks just go up.

We agree on J Powell too.  He does not intend to allow the market to dip.  That is not really his job but he knows he'll be job hunting if he doesn't play the game for politicians.  This is all about excess liquidity. Can the market be saved next time with -2% rates?   How about -5% the year after that?  I don't know the answer because we have never been here before.  In the mean time "investors" will give themselves a high five for buying or holding through what seasoed investors consider an irrationally high multiple.  

Hear me now, believe me later, asset bubbles do pop.      Don't ask me when.  I am not an angry old value investor sitting on cash.  I try to be a little cautious and have a little extra cash but I am not afraid to play the game.  At all times I own a few speculative stocks.  They go up to my disbelief and I look for the next ones.  Meanwhile some of my conservative plays flounder, but mostly they just go up gradually too.  The rising tide does lift all portfolios.  

The only thing I am sure of is I am not sure what happens the next few years. That would require some arrogance.  I mix it up and hope I can get some of the prize and avoid some of the downdraft should it occur.  That day will come.  It seems it IS different this time due to never seen FED tactics, but I truly believe valuation principles are not dead forever.  Bad balance sheets don't matter at all today but maybe they do eventually?

I hope the thread gets more participation.  IMO it's the most important trend going on for years now.

[Golden99]

Great Topic. My opinion goes as follows.

The principles of value investing as proposed as applied by B. Frankklin, Buffets and the likes are very sound and correct, but hardly applicable for the modern private/passive investor. The reason is, once the tenets of a working strategy are well known and studied, the market integrates them and gets closer to full efficiency. It takes some level of self confidence (arrogance ?) to believe that one has valued a company correctly while huge funds and institutional investors with advanced algorithms and computers have failed to see that. Such opportunities may still arise, but more often than not, it is likely to be a value trap.

all things (Rewards) being equal, I believe quality dividend stocks are a better/safer bet for a passive/private investors using only his excel sheet. Alternatively an index fund would make some sense, but thats beyond the topic.

[fenders53]

Are the algorithms even looking for value in any meaningful way? I suspect they are not other than perhaps a value ETF.

I agree the strategies of Buffett and Graham are less relevant without adjustment. Buffet's most successful investment in decades is AAPL. Arguably getting overvalued now but it wasn't when he entered.

S&P 500 PE 15 may be over forever. I suspect the correct answer is not 25+ for companies growing earnings at sub 5%. We will find out in a few years when unsustainable deficit spending is throttled back. Low interest rates for a decade will cloud the outcome. IMO equity investments are completely dependent on that at these valuations.

For now I will mix it up. I've had a new opinion on what was better each of the last three decades. We'll see about the 20s. I've never thought near zero growth is a winning strategy. That may be the only principle that held up throughout. The market currently doesn't care if your balance sheet is reckless but that may not be a permanent change.

[ken-do-nim]

Lately, I've been investing by "compelling story".

Eli Lilly because Alzheimer's treatments would be a real game changer.
Moderna because covid shots look like they are around to stay, plus they may someday have an HIV vaccine.
China/India/Southeast Asia industrialization drives a need for steel (Rio Tinte), network infrastructure (Cisco), databases (Oracle), and storage (Seagate).
Intuitive Surgical because its product results in far less malpractice suits and again is a real game changer for surgeons.

But of course sometimes that story changes, such as when China decided they would cut back on their steel production because of the carbon emissions, and bam, Rio Tinte dropped like a stone. I'd still like to add it back to my portfolio when I feel it has found a bottom.

[Kerim]

Great thread, and interesting ideas. As a very general matter, I'd prefer an excellent company that is at fair value or somewhat above than an average or worse company that is undervalued. But of course it isn't binary, and all of those metrics are very subjective. And it will always be a case-by-case call involving a variety of factors.

But really, nothing is making much sense to me these days. Not the markets, not the economy, not society. It used to be that my crystal ball just didn't work at all. Now it is actively feeding me disinformation, I think. I seems to me we're in for a pretty serious reckoning, but maybe not for a lot of years still. With so much money sloshing around the world these days -- we're really at a loss for where to put it all at this point -- a serious and prolonged correction is hard to imagine. But maybe that's just the recency bias again. My instinct for this next chapter is to start dropping my smaller and more speculative positions, and keep building those core, best in class positions as opportunities merit.

[fenders53]

We'll never time a crash and we'll survive a typical correction. All you can do is allocate in a manner you are comfortable with.

Unlimited liquidity could run this thing up for years. My concerns are US equities are high to include stocks that would protect from half the pain. I am not convinced an aristocratic 20% overvalued accomplishes that. Every bond market on earth is overvalued. Real estate is bubbly so that's out.

I will just lean value and have some cash. I always feel much better when I can buy low. I don't want to avoid growth but I will lighten up fast if the market drops for a valid reason.

[ken-do-nim]

(08-28-2021, 08:53 PM)fenders53 Wrote: We'll never time a crash and we'll survive a typical correction.  All you can do is allocate in a manner you are comfortable with.

Unlimited liquidity could run this thing up for years.  My concerns are US equities are high to include stocks that would protect from half the pain.  I am not convinced an aristocratic 20% overvalued accomplishes that.  Every bond market on earth is overvalued. Real estate is bubbly so that's out.  

I will just lean value and have some cash.  I always feel much better when I can buy low.  I don't want to avoid growth but I will lighten up fast if the market drops for a valid reason.

I have to admit if I were preparing for retirement now, I wouldn't have a clue how to allocate my assets.