Some Valuations Are Too High
by Charles Rotblut | April 01, 2021
Special Note: The U.S. financial markets and our offices will be closed tomorrow, Friday, April 2, in observance of Good Friday. We wish those of you celebrating the religious holidays a respective happy Easter and happy Passover.
Is there an upper limit to the valuations that investors in high growth and emergent stocks should pay? It is a question whose answer I discussed in last week’s VMQ Stocks commentary. I’m going to expand on the answer a bit more here.
There is an upper range to valuations even growth investors should pay according to Leuthold Group’s director of research Scott Opsal. Beyond a certain point, stocks underperform the broader market and, at extremely high valuations, cost investors money. Here’s what Opsal wrote in a recent report:
“A P/S ratio greater than 3 has essentially produced market returns, while raising the P/S limit to 6 produces a slight degradation in spread. This declining trend continues … until P/S ratios above 18 show zero absolute return and lag the market by more than 10% annually. A P/S ratio above 12 produces a clear deficit, but we felt that a P/S above 15, marked by a return shortfall of –5.8%, was the point at which we could definitively say that 15 is ‘too high’ to achieve consistent investment success.”
A price-to-sales (P/S) ratio of 15 is lofty territory. Out of nearly 4,900 exchange-listed stocks, just 530 have a price-to-sales ratio of 15 or higher. Most (80%) of these companies were not profitable last year.
High valuation. No profits. Not a good combination.
Opsal’s analysis matches the long-term data we’ve seen for other valuation criteria. Dartmouth professor Kenneth French’s online database provides historical data for the price-earnings and the price-to-book ratios. In both cases, there is a substantial drop in annualized returns for portfolios of stocks with valuation ratios ranking in the most expensive decile (most expensive 10%).
Portfolios comprising stocks with price-earnings ratios ranking in the most expensive decile realized an annualized return of 9.7% for the period of 1952 through 2020. This compares to an annualized return of 13.8% for stocks in the middle fifth decile and 18.2% for stocks whose price-earnings ratios rank in the cheapest 10%.
A similar story exists for the price-to-book ratio. Portfolios comprising stocks with price-to-book ratios ranking in the most expensive decile realized an annualized return of 6.9% versus 13.4% at the fifth decile and 18.7% at the cheapest decile between 1952 and 2020.
In both cases, returns rise as valuations become cheaper and returns worsen as valuations get more expensive. This is why both A+ Investor and VMQ Stocks assign a Value Grade of F to stocks whose relative valuations rank in the most expensive 80%.
Which ratios sit in rarefied air? Price-to-sales ratios ranking in the most expensive 20% are currently 8.7 or higher. Price-earnings ratios ranking in the most expensive 20% are 51.0 or higher. For the price-to-book ratio, the number is 6.9 or higher.
Is there a valuation metric you think is simply too high? Tell us in the comments section below.
- Former T. Rowe Price Growth Stock fund (PRGFX) manager Robert Bartolo suggested that investors should consider whether a company can turn rising sales into rising earnings when evaluating growth stocks.
- Whenever a certain category of stocks or other assets is doing well, exchange-traded fund (ETF) providers create new funds to track them. These specialized ETFs often deliver poor risk-adjusted returns.
- The April AAII Journal is now online.
- The Model Shadow Stock portfolio targets micro-cap stocks whose valuations rank in the cheapest 10%. This emphasis on small-cap value has led to strong one-year and long-term returns as AAII president John Bajkowski explains in the April AAII Journal.
- Bajkowski will discuss how to take advantage of the many benefits AAII membership provides in a special webinar on Wednesday, April 7.
AAII Sentiment Survey
Optimism among individual investors about the short-term direction of the stock market pulled back to a four-week low. The latest AAII Sentiment Survey also shows neutral sentiment at a four-week high.
Bullish sentiment, expectations that stock prices will rise over the next six months, fell 5.1 percentage points to 45.8%. Optimism is above its historical average of 38.0% for the 18th week out of the past 20 weeks.
Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, increased 2.5 percentage points to 31.0%. Neutral sentiment remains below its historical average of 31.5% for the 59th time out of the past 63 weeks.
Bearish sentiment, expectations that stock prices will fall over the next six months, rose 2.6 percentage points to 23.2%. Bearish sentiment is below its historical average of 30.5% for the eighth time this year.
At current levels, all three sentiment readings are back within their typical historical ranges. Last week, bullish sentiment was unusually high and bearish sentiment was unusually low.
The ongoing coronavirus pandemic, including the distribution of vaccines, continues to have a big influence on individual investors’ outlook for the stock market. Other factors include the new administration’s policies, economic trends, the current level of valuations and economic stimulus.
For this week’s special question, we asked AAII members which industries or sectors they think are attractive buying opportunities in the current market environment. Several respondents provided more than one response.
Approximately 17% of respondents list technology stocks, followed by industrial companies being favored by 13% of respondents. This compares to 12% of respondents who think the health care sector is an attractive buying opportunity and 11% of respondents who say that basic materials and commodity companies are attractive. In addition, about 8% of respondents highlight the financials sector and 8% of respondents are liking the energy sector.
Other sectors and industries named include: consumer cyclicals (named by 6% of respondents); travel (named by 5% of respondents); and banks (named by 4% of respondents).
Here is a sampling of the responses:
- “Cyclical and materials as well as beaten-down stocks affected most by the coronavirus but have the financial ability to survive. I would avoid, for now, travel stocks including cruises which may have more difficulties to overcome. But hotels and restaurants are opportunities.”
- “I believe innovative health care companies will continue to perform well. Bonds are on their way down in price as yields rise. I think the ‘hot’ names are due for a rest and we may see more of the old line industrial names with strong balance sheets rise over the next several months.”
- “It is hard to say because of high current stock prices, but I think both money center and regional banks will benefit from slowly rising interest rates. And selected small-cap industrials like Miller Industries will see its customers return to spending on their capital needs resulting in greater sales.”
- “With the recent pull back in some large tech stocks, they seem to be at attractive levels again.”
Bullish: 45.8%, down 5.1 points
Neutral: 31.0%, up 2.5 points
Bearish: 23.2%, up 2.6 points
Bullish: 38.0%
Neutral: 31.5%
Bearish: 30.5%
See more Sentiment Survey results.
AAII Asset Allocation Survey
Individual investors’ exposure to equities reached a 37-month high in March according to the latest AAII Asset Allocation Survey. Fixed-income allocations, meanwhile, declined to a 29-month low.
Stock and stock fund allocations increased by 2.3 percentage points to 70.0%, marking the 10th consecutive month that equity allocations are above the historical average of 61.0%. Equity allocations were last higher in February 2018 (70.1%).
Bond and bond fund allocations pulled back by 0.7 percentage points to 15.3%, falling below its historical average of 16.0% for the first time since February 2019 (15.8%). Fixed-income allocations were last lower in October 2018 (13.3%).
Cash allocations decreased 1.5 percentage points to 14.7%, marking a 14-month low and the 11th consecutive month cash allocations have been below their historical average of 23.0%. Allocations in cash were last lower in January 2020 (13.8%).
Individual investors’ exposure to equities reached an unusually high level in March (more than one standard deviation above the historical average). Bullish sentiment was at an unusually high level throughout much of March. At the same time, rising stock prices and falling bond prices shift allocations—even for those investors who made no changes to their portfolios.
- Stocks and Stock Funds: 70.0%, up 2.3 percentage points
- Bonds and Bond Funds: 15.3%, down 0.7 percentage points
- Cash: 14.7%, down 1.5 percentage points
- Stocks: 30.8%, up 1.8 percentage points
- Stocks Funds: 39.2%, up 0.5 percentage points
- Bonds: 2.4%, up 0.3 percentage points
- Bond Funds: 13.0%, down 1.0 percentage points
- Stocks/Stock Funds: 61.5%
- Bonds/Bond Funds: 16.0%
- Cash: 22.5%
Take the Asset Allocation Survey.
March 25, 2021 One Year Later: Seven Lessons From the Coronavirus Bear Market
March 18, 2021 A Quick Tax Update, Plus a Look at Projected Earnings for 2021
March 11, 2021 Diversification's Impact Depends on Time Measured
March 4, 2021 Warren Buffett Shares His Thoughts About Shareholders
Discussion
PMac from California posted over 5 years ago:
Valuations are obviously too high. The problem is they can go even higher. However, the market will eventually correct. It is not if but when. You can print all the money you want but you cannot create value by money printing. If that method worked, Russia and Venezueala would be the envie of the world. The course we are on is like standing on a railroad track and hearing the faint sound of a trail whisle. Stay where you are and get run over by the train. When, nobody knows but that train is coming.
Robert from Missouri posted over 5 years ago:
Where fools rush in angels (and investors) should fear to tread. But for the moment momentum appears to the upside. Reality will sink in at some point but for now the direction seems to be to the upside. My favorite charting tool of the quarterly SP500 stocks shows SP500 above the upper Bollinger band (one statistical deviation above the 20 quarter moving average) which usually implies a continuation. Likewise well above the parabolic and the slow stochastic is positive along with MACD. While a fundamental investor, I do watch the technicals and at the moment they are showing continuation despite fundamental issues. And less stretched Russell 2000 has so far this year far out performed the more expensive DJIA , SP500 and NASDAQ. I expect a correction, probably this summer, but this is typical of a bull market once the parabolic turns positive as it did last year. With low interest rates traditional valuations have become very stretched. But at what point does the rubber band break? Time will tell. I am old enough to remember the nifty fifty of the 1970's. Could not lose money... until you did!
Frank from NC posted over 5 years ago:
I’m disappointed by the generalizations in this analysis. Comparing a modern software company to a 1960 industrial stock doesn’t tell us anything. I subscribe to Morningstar, who is generally pretty conservative in their discounted cash flow analysis. Even they have fair values of many companies equating to 8, 12, and even 20x sales. Think Adobe, salesforce, Intuit, Shopify and many others. It would be more helpful to isolate the sectors with these characteristics rather to discard them based on this simple valuation measure.
Barry J from TX posted over 5 years ago:
A lot of the BIG, SMART money folks are getting "FAT" by betting that the "FAATMAN" stocks (FB, AMZN, AAPL, TSLA, MSFT, GOOG, and NFLX) will grow into their P/E's. Their revenue grow curves are comparatively steep and most have higher, accelerating revenue growth slopes. All but one are on the TOP 10 largest US companies list by market cap, which says somebody is betting money on them.
You need to log in as a registered AAII user before commenting.
Create an account