The Market Is Overvalued, What Can You Do?


With the S&P 500 up 40% over the last two years, stocks have gotten more expensive, and it's tougher to find value. Sound obvious? You're not the only one who thinks so. Here's what a fellow Fool tweeted at me earlier in the week:

This idea that value-fishing ponds aren't nearly as stocked as they were was a key theme at this year's Value Investing Congress in New York. I spent the first two days of the week at the VIC listening to one value manager after another lament this development.

Coming to such a conclusion isn't all that hard. While I don't recall anyone at the conference trotting out Robert Shiller's CAPE measure (a long-term price-to-earnings valuation measurement), we could of course look at that. In September 2011, the CAPE was below 20, and today it's getting close to 24. If you're a believer in the CAPE, it's really quite simple: A higher multiple equals lower future returns.

As VIC presenters pointed out though, valuation creep is readily evident in individual companies. Michael Castor of health care-focused Sio Capital mentioned MWI Veterinary Supply and Stericycle as examples of stocks that have stretched valuations. For the numbers inclined, Capital IQ lists the respective trailing price-to-earnings multiples at 31 and 35. Meanwhile, Mark Boyar of Boyar Asset Management compared Zillow's current valuation to the lunacy that took place during the dot-com bubble. Zillow trades at 23 times trailing revenue.

What's left to do? Agora Financial's Chris Mayer put it well, quipping: "We invest in the market we have, not the market we wish we had."

But what the heck does that mean?
We could spend our time being reminiscent of 2011 -- or 2009 for that matter -- and all of the bargains available back then. But it's 2013, and pining for past valuations won't help our portfolios grow today. As value-investing great Donald Yacktman pointed out at the same conference, the goal for his funds is to first protect capital, and then grow it. The emphasis on the latter part was that you can't let capital just sit under a mattress -- not only will it gather dust, but its value will be eaten alive by inflation.

For many of the VIC presenters, the answer was to head to more obscure areas of the market for their investments -- small, uncovered, often international. For Mayer, it was a little of all three as he pitched the idea of owning a basket of small thrift banks undergoing demutualization conversions and (separately) a Canadian seismic data company (Pulse Seismic Inc).

Others found value by going relative -- that is, where they saw value relative to other asset classes after adjusting for risk. Yacktman, for example, said that thanks to high valuations, he doesn't think investors are getting adequately compensated for taking risks on smaller, lower-quality companies, so he's sticking with safe, high-quality picks. Across his funds, Twenty-First Century Fox, Procter & Gamble , and PepsiCo are the largest holdings.

Your task... should you choose to accept it
The bottom line is that if you subscribe to the "there ain't as much value out there" theme, then it's more important than ever to make sure that you're getting value in what you're buying. That doesn't necessarily mean that what you're buying needs to be traditionally cheap on a simple valuation-multiple basis, but it does mean you've done the work to prove to yourself that you're getting an asset worth more than what you're paying for it.

If the ideas at the VIC were any indication, there's no one way to go about finding the value still hiding in the market. But after a few years of big, easy returns, investors need to make sure they haven't been lulled into a false sense of security.

Here's one big idea
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Matt Koppenheffer has no position in any stocks mentioned. The Motley Fool recommends PepsiCo, Procter & Gamble, Stericycle, and Zillow. The Motley Fool owns shares of PepsiCo and Zillow. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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