Where to Invest When Stocks Are Too Expensive
A Note From the Managing Editor: Today’s essay comes from our good friend Adam Sharp. Adam and his business partner Andy Gordon are our go-to authorities when it comes to startups. (And we’re not alone - their free e-letter, Early Investing, boasts more than 180,000 subscribers.) Below, Adam explains how everyday investors like you can get the biggest bang for your buck in this fast-moving space.
Over the last few weeks, I’ve been on the hunt for stock market bargains.
I’m participating in a charity stock-picking contest, and fundamental investing is what I know best.
Well, I’m not having much luck so far.
The S&P 500’s price-to-earnings ratio is currently around 25 (trailing 12 months).
By comparison, the Nasdaq 100 looks reasonably priced at a P/E of 15. There appears to be room to run in tech stocks. But it’s important to remember that today the Nasdaq 100 is mature and massive, being composed of companies like...
- Alphabet (Nasdaq: GOOG) - $584 billion market cap
- Apple (Nasdaq: AAPL) - $650 billion market cap
- Amazon (Nasdaq: AMZN) - $406 billion market cap
- Cisco (Nasdaq: CSCO) - $154 billion market cap.
There are some fast growers in there, but I wouldn’t say they’re necessarily inexpensive.
One of the only markets I’ve been able to find bargain stocks in is Russia, which is fraught with all kinds of risk. Namely sanction uncertainty, currency fluctuations and a dubious future relationship with the U.S.
Still, with Russian stocks trading at an average P/E of 7, it’s attractive compared to many markets.
Overall, I’m not saying markets are priced ridiculously here.
They’re just not cheap.
This is one of the reasons I like startups.
No matter what the public market looks like, there are usually good startup deals to be found.
Especially at the earlier stages.
The Key to Finding Good Deals Today
Startup valuations (the price at which you invest) don’t move in lockstep with stocks. Sure, when the market is moving up, valuations tend to rise a bit. But startups move in a different cycle.
For example, today, startup valuations are a bit lower than they were two years ago (for comparable companies). In contrast, stocks have risen around 11% in that time.
But the key is that even during pricey market times, early-stage startups stay relatively cheap.
These are known as Seed and Series A rounds (the first batches of money a startup raises).
The first round of funding tends to value startups anywhere from $3 million to $20 million. It depends on their traction, teams and ability to impress investors. And it tends to stay around that same range, no matter the market conditions.
You might think that a startup founder would want the highest valuation he can get. Nope. A smart founder wants a fair valuation - for everybody’s sake.
Because if a company raises money at too high of a valuation, it can hurt the company even more than the investors. If the first round is too high, that makes getting additional rounds of funding much harder. And it makes the notorious “down round” more likely.
So the key to investing in startups at fair valuations - regardless of market conditions - is to do so early. There’s more risk, but there can also be far more reward.
An example from my own portfolio is Navdy, a startup that makes a “heads-up display” for cars. I invested a small amount back in the summer of 2014, during its seed round of funding.
That was before it had begun manufacturing and even before it had launched its pre-order campaign. But it had a good leader, an impressive prototype, great marketing and backing from a solid VC firm.
In this case, the calculated risk paid off. Navdy wound up shipping a great product, which I have in my car today.
Early-stage investing takes patience, risk tolerance and diligence. But when one of your startups takes off, it’s worth all of that and more.
Founder, Early Investing
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P.S. Our research service First Stage Investor specializes in exactly these types of early-stage deals. In fact, we have a number of current recommendations where the companies are valued from $4 million to $15 million. If you've ever been intrigued by the idea of investing in private tech startups, see our presentation here.