In many articles posted here, I’ve always mentioned my uneasiness in passively indexing even if many indications tell me that some index funds are over-valued. This uneasiness also extends to being fully invested in investment strategies such as Magical Formula when the whole stock market is at over-valued territory.
The crux? Relative Valuation.
Relative Valuation is basically valuing an investment that is cheap relative to the general market instead of valuing an investment based on specific parameters. A great example is Walter Schloss’ investing, where he had to shift towards buying low P/B stocks (Relative Valuation) because most NNWC stocks (Absolute Valuation) were in very short supply.
To understand my uneasiness, you need to understand how people profit from investing in stocks, which boils down to one formula: Profit/Loss = (Company Earnings * Earnings Multiple) + Dividends
What the formula summarizes is that you only make money when three variables changes, which is Company Earnings (if increase in Company Earnings offset potential drop in Earnings Multiple, you profit), Earnings Multiple (if increase in Earnings Multiple offset potential drop in Company Earnings, you profit) and Dividends (if Dividends were more than losses caused by Company Earnings * Earnings Multiple, you profit).
Breaking down the formula further, you will realize that profits are driven by both fundamentals and sentiment, fundamentals being Company Earnings and Dividends, while sentiment being Earnings Multiple (essentially how much people are willing to pay for each dollar of earnings).
An example would be P&G, where its revenue, gross profit and net income has been relatively the same from 2010-2014, yet its price (and thus P/E) has been climbing steadily since 2010. If you were to have bought P&G stocks in 2010 and sold it now, you would be profiting mainly through sentiment.
Revenue, gross profit and net income of P&G from 2010 to 2014, taken from Morningstar.
Stock price of P&G from 2010 to 2014, taken from Google Finance.
The danger of sentiment is that the stock market could be horribly over-optimistic with how much it is willing to pay for each dollar of earnings. Quoting George Soros’ explanation of Theory of Reflexivity, “Negative feedback brings the participants’ views and the actual situation closer together; positive feedback drives them further apart“, thus the more optimistic the market is, the more detached from reality the market is.
And the more detached from reality an investment is, the less margin of safety, and the higher possibility of a price drop that won’t see prices revert back to its previous peak for a long time.
Going back to the comparison between Relative Valuation versus Absolute Valuation, Relative Valuation’s profitability is much more easily affected by sentiment than by Absolute Valuation, since if stock prices dropped even though I bought at a higher price using an Absolute Valuation, it was still a bargain when I initially purchased it due to Absolute Valuation.
As such, for investment strategies such as Magical Formula which relies heavily on Relative Valuation, there is a strong need to hedge against market over-valuation, and I think a very effective method is to spot the amount of NNWCs available in the stock market you’re investing with Magical Formula with. If there are >20 NNWCs, then I’d be fully invested in a Relative Valuation strategy, but if it drops below 20 then my hedge will be (1 – No. of NNWCs / 20). This is basically emulating what I would do if I were investing NNWCs, which is to never invest more than 5% of my portfolio in any NNWC stock and hold cash if there’s less than 20 NNWCs to invest in.
Not advice. No offer. Do not rely. May lose value. Risky. Conflicts hidden/obscured. (Borrowed from Terrence Yang‘s Disclaimer on Quora)