Investors, Do You Make This Rookie Mistake?

What has happened to our market? A month ago, the ASX 200 was budding the 6,000 point mark. But throughout May and early June, we quickly lost most of those gains. It’s only been in the last few days that the market has rallied to around 5,800 points, up 2.46% year-to-date (YTD).

We haven’t as yet fallen below 5,500 points. But I wouldn’t be surprise if it happens sometime in the next few months. Telecoms and financials are dragging the market down. If other sectors start to fall, we could soon be looking at negative returns YTD for the ASX 200.

In the US it’s a completely different story.

The S&P 500 has continued its climb in 2017. The index is up 9.5% for the year – a massive climb in just six months. But it’s got many US fund managers worried.

Americans pay higher prices

I don’t doubt there are opportunities in the US market. There always are, no matter what the market does. But as the market climbs higher, opportunities become scares. What do most investors do in when they can’t find cheap stocks?

They continue to buy. Fund manager, Bill Gross believes instead of buying low and selling high, investors buy high and cross their fingers.

Take a look at the graph below. It shows the price-to-earnings (P/E) ratio of the S&P 500 over the last five years.

Source: Bloomberg

Click to enlarge

Think of the P/E as the price you pay for earnings. For example, if you buy a pizza shop for $500,000 and it produces $100,000 each year, it has a P/E of 5. Put another way, you paid $5 for every $1 of earnings.

The P/E of the S&P 500 has continued to climb in 2017. US investors are looking at a market trading around 21-times earnings. Is that high? Well, the quarterly average dating back to 1954 is around 16-times earnings. So yes, 21-times earnings is pretty high.

And as Gross said, many of them are hoping growth is just around the corner. But it’s not just valuations that professional money managers are worried about.

The aftermath of the crisis

Founder of Elliott Management, Paul Singer believes there’s simply too much debt in the market. Singer said at the Bloomberg Invest Summit in New York:

What we have today is a global financial system that’s just about as leveraged and in many cases more leveraged than before 2008, and I don’t think the financial system is more sound.

Why is there so much debt? I’d blame the US Federal Reserve. They’ve kept interest too low for too long. They justify low rates as a means to drive economic growth. Yet all it’s really done is drive asset prices sky high.

As Gross explains:

Money is being pumped out into the system and money that is yielding less than nothing seeks a haven not only in bonds that are under-yielding but in stocks that are overpriced.

The problem with a lot of debt is the risk of rising interest rates. Interest rates around the world still relatively low. But the US might now be entering a rate hiking period, putting pressure on businesses carrying a lot of debt.

Just a month ago, the Fed acknowledged a temporary weakness in the economy. Yet they were still determined to move ahead with policy tightening. Economists believe the Fed will hike interest rates again in June.

So what happens when interest rates rise and there’s a lot of corporate debt in the system? You get substantially lower profits. And as profitability shrinks, inflated valuations rise even higher.  It’s a very troubling situation a lot of US investors might not have thought about.

Price is the ultimate gate way to returns

If you ask me, you are far better off investing in Australia right now than the US.

Sure, the US has a larger more diverse stock universe. But right now, they’re paying a lot more for earnings than they did in the past.

Both the ASX 200 and the All Ordinaries are trading very close to their historic averages. I’d argue you have a better chance of finding ‘cheap’ stocks in the ASX 200 than the S&P 500.  Of course you have to find out if a company is cheap because of a systemic problem or a temporary lull.

But a lot of the time, the price you pay will ultimately dictate your returns. It pretty common sense right? The lower you pay for an investment, the better chance you have to capture more share price growth.

Yet as I’ve shown, US investors are more than happy to pay high prices today and hope for even higher prices tomorrow.

Instead of chasing growth, I suggested you focus on price when thinking about future investments. That means not jumping into the next ‘hot’ stocks or the next ‘booming’ industry. Instead, you would carefully choose investments which have the best possible chance to appreciate over time.

I’ll use an example to explain what I mean.

Imagine you had the chance to buy one of two companies more than five years ago.

You’re options are either Challenger Ltd [ASX:CGF] a billion dollar company that offers income investments to retirees and super funds or InvoCare Ltd [ASX:IVC] a growing $284 million funeral company.

Leading up to 2012, InvoCare continued to grow revenues and earnings. And in FY12, InvoCare’s earnings per share jumped a massive 57%.

Investors had high hopes for the company. In fact, they liked InvoCare so much that they bid up the stock to 30-times earnings as of 3 January 2012.

As a comparison, the boring income company, Challenger was growing at a much slower rate.  And it was reflected in their valuation. The stock traded for 7.7-times earnings at the start of 2012.

Most investors would’ve invested in InvoCare, right? It probably wouldn’t have been such a bad idea. Since 2012, InvoCare is up 90%. Yet, it’s not enough to beat Challenger, which has appreciated 209.5% over the same period.

While you would have made money on both investments, you’re returns are far higher when you focus on buying stocks which are cheap. Let me be clear, buying ‘cheap stocks won’t always lead to huge returns.

A lot of the time businesses are cheap for a good reason. Their business model might be outdated or earnings might be substantially lower going forward.  But by starting with cheap stocks and dividing the good from the bad, you have a great chance of increasing your portfolio returns.

Regards,

Harje Ronngard,
Contributing Editor, Money Morning

PS: You can still find value in the market. But who has the time to pour through hundreds of companies each week? Greg does. In Greg’s advisory service, Crisis & Opportunity, he looks for companies which are out of favour.

Not only are these stocks cheap, they can also significantly appreciate in the future. Just a few of Greg’s recommendations are already up 28.4%, 27% and 51%.

To find out more, click here.


Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the stories that make a difference to your wealth. Whether you agree with us or not, you’ll find our common-sense, thought provoking arguments well worth a read.

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