A model portfolio would have small to medium cap companies.
Are markets overvalued? Yes they are. But this does not tell you anything. Markets are never fairly valued. They are either over or under valued.
Using CAPE data which goes back to 1950, it shows markets have been overvalues since 1992. So markets have been overvalued for 25 years. Is this helpful with the question of overvaluation? Has the world changed over the past 67 years?
First the interest is a big change. The cost for investing is a lot lower. We have access to cheaper funds. Investing is globalized. Do these trends justify an adjustment to the long-term average? He is using US data as it is better and more available than Canadian data.
Current average P/E is 22.8 and the historical average is 16.55. This infers a 37% overvalued market. Post internet the average is 19.95. With current at 22.8 it implies a 14.3% overvaluation. (Note that before 1991 the historical average P/E Ratio was 11.54.) An overvaluation of 14.3% is not that bad. If the proliferation of the internet started a stark shift in valuations, why should we use a simple average?
There is an argument that a dollar is a dollar and the utility of a dollar in the past is still the same in the future. But could the potential return on a dollar change over the years? Today the cost of starting a business is cheaper. You do not need to sink as much costs in plants and employees. There is less start-up risk. There is then more room for error (and less need for lower valuations).
The markets are overvalued. But, by how much are they overvalued? Markets are always over and undervalued. Over 20% overvalued is bad. 10 to 15% overvalued can be taken care of in a year. There is less need to worry about overvaluations if you have a long time frame.
The likelihood of positive and negative returns for the market over various time periods is shown below: That is if you do not time the market. Over a 20 year time frame the market is up 100% of the time. It is best to have a 10 year time frame rather than a 5 year one.
| Period | Positive Return | Negative Return |
|---|---|---|
| Daily | 54% | 46% |
| Quarterly | 68% | 32% |
| One year | 74% | 26% |
| Five Years | 86% | 14% |
| Ten Years | 94% | 6% |
| Twenty Years | 100% | 0% |
The average life expectancy as of 2015 is 82 years. You can be 50 or 60 and have high degree of confidence in the market. Even if the market is at the top, over the long term you can come out even. Markets do go up over the long term.
There is a momentum premium. Mark Carhart found evidence of this and extended the Fama-French modal. Stocks that have upward momentum have a tendency to continue to go up. (There is a Wikipedia entry on this subject.
There is a size premium. Smaller companies tend to outperform bigger ones. Stats show this but it is debatable. Small cap is less correlated to the market. There is less analysis and investor interest in them. Small and mid-cap investors can be less concerned with the market. Smaller companies have faster growth. They can grow revenue from a small basis. A sale of $10M means more for a small company. A small company can succeed on a one deal; a large company needs more deals all the time. Growth is easier for a small company.
You can have a large company with little cash and lots of debt on its balance sheet and a smaller company with lots of cash and little debt. The smaller company is a saver. Large size does not mean safe.
Also, patience pays. A small company will mess up a quarter now and then. A small company may lack finesse, but business could be doubling or tripling. Many CEOs need quarterly results to keep their jobs.
Inefficiency can mean opportunity. Smaller companies can have less research and less defenses. They can mess up sometimes. However, more risk is more opportunity.
Companies he likes include Photon Control Inc. (TSX-PHO) which has a lot of cash and is selling at 15.5 times EPS. Another one is Crius Energy Trust (TSX-KWH.UN) which is growing revenue and dividends. It sells at 6 times cash flow. He also likes Absolute Software Corp (TSX-ABT) which has 34M in cash that is 11% of their market cap. The last ones is Knight Therapeutics Inc. (TSX-GUD) because their cash is 65% of their Market Cap and they are waiting for the right time or thing to invest.
On my other blog I wrote yesterday about Dollarama Inc. (TSX-DOL, OTC-DLMAF)... learn more. Next, I will write about Keyera Corp. (TSX-KEY, OTC-KEYUF)... learn more on Wednesday, November 15, 2017 around 5 pm.
This blog is meant for educational purposes only, and is not to provide investment advice. Before making any investment decision, you should always do your own research or consult an investment professional. I do research for my own edification and I am willing to share. I write what I think and I may or may not be correct.
See my site for an index to these blog entries and for stocks followed. I have three blogs. The first talks only about specific stocks and is called Investment Talk. The second one contains information on mostly investing and is called Investing Economics Mostly. My last blog is for my book reviews and it is called Non-Fiction Mostly. Follow me on Twitter. I am on Instagram. Or you can just Google #walktoronto spbrunner8166 to see my pictures.
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