A Better Way to Invest in an Expensive Market

by Adam Sharp, Co-Founder of Early Investing LLC
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Benjamin Graham, widely considered the father of value investing, once said, “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.”

In other words, over short periods, markets tend to move irrationally along with market psychology. But over longer market cycles (at least 10 to 12 years), fundamentals are ultimately what matter.

Since 1996, the U.S. stock markets have acted almost entirely like voting machines. Only during brief bear markets and corrections do they seem to act like weighing machines.

The chart below shows the average price-to-earnings ratio of the S&P 500 since 1970.

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As you can see, for the last two decades, stock market P/E ratios have been elevated most of the time. Since 1996, the average P/E has been 23.36. Meaning that stocks are almost always expensive. And dividend yields are almost always low.

Only during brief and sporadic crashes and corrections do we get a chance to buy stocks at bargain prices.

The average bear market lasts around 15 months (since 1900), though they vary widely. The crashes happen fast, while the bull markets take years to peak.

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Now, once again, we find ourselves facing historically pricey stocks pushing higher and higher.

Clearly, it’s good to own some stocks for the long run. So you can either “dollar cost average” into it (invest the same amount monthly over years), or try to time it using stops and/or gut feeling.

Both strategies can work, but they have their own drawbacks. Dollar cost averaging into stocks means that you’re overpaying most of the time.

Trying to time the market is difficult and can be terrifying.

Personally, I use a combination of the two for stocks. I mostly dollar cost average into stocks I want to own forever. But I do hold on to more cash when stocks are pricey, take some profits, and wait for a correction or crash. It’s the modern version of value investing.

The Cause and Result

I believe this problem is primarily created by persistent low interest rates.

Eight years of near-zero percent interest rates have distorted markets greatly.

The sheer size of government as a percentage of the economy is also problematic, since large bureaucracies are woefully inefficient. But that’s another article entirely.

It’s primarily these low rates that have convinced the market that risk/speculation will be rewarded. And it’s “working” in the sense that stocks are going up due to artificial forces acting on them.

Toss in the rise of algorithmic trading funds, which now make up 27% of all stock market volume, and the moves are even harder to predict.

This is probably why 90% of actively managed funds have underperformed against their indexes over the last 15 years. That’s 1.5% a year for a cumulative gain of 25% for the Jack Bogle fans.

Startups: A Market That Always Has Bargains

I still own public stocks, don’t get me wrong. But that stuff is mostly on autopilot, with a few exceptional cases.

Ninety-five percent of my attention is on startup equity these days.

With startups, you can almost always find attractive investments. It’s truly one of my favorite things about this private market.

At the early stages, there will always be reasonable founders out there who know they should raise money at a reasonable valuation.

Overpricing a startup damages the founder as much as the investor. Experienced founders know this. They’ve seen companies raise money at valuations that are too high...

When it’s time for its next round of funding, the company typically struggles (unless it’s taking off like a rocket). The startup may then have to raise cash at a lower valuation in a “down round.” That’s a bummer for everyone.

Sure, there are times when seed-stage investments get pricier. When new pre-revenue companies are successfully raising seed money at $10 million valuations, that’s overpriced. (Unless there’s a legendary founding team or some other extraordinary circumstance.)

But not all startup deals at any given time will be overpriced. There will always be bargains in such a small inefficient market. (And I mean inefficient in a good way.)

Think about it. These companies are often raising $500,000 to $1 million. That means only so many people will even see the deal before it either fills or fails. With startups, there is limited “price discovery.” This is a good thing, as it keeps valuations reasonable.

When deciding whether a startup investment is a good value, I look at a number of factors.

  • Is the product valuable?
  • Can the company sell that product?
  • How much would it cost someone else to build it?
  • How much money can the company realistically generate five years out?
  • What’s its edge?
  • How defensible is it?
  • How attractive is it as an acquisition target?
  • How well has it used the capital it’s raised so far?

These are the types of questions I like to ask when investing in a company. It’s why I’m naturally drawn to startups.

With stock trading, the question you’re asking is “Will it go higher for a bit?”

I’d much rather be asking the startup questions when investing. Success boils down to using intuition, curiosity and diligence. That’s what investing should involve.

Today’s stock market feels a long way from those questions. It’s more about trying to correctly predict short-term winners.

Good investing,

Adam

Thoughts on this article? Leave a comment below.

P.S. My colleague Andy Gordon just released a detailed presentation on why he believes the stock market has likely peaked for the foreseeable future. Perhaps most surprisingly, his research shows that a little-discussed 2002 SEC regulation could trigger a major market sell-off within the next few months.

The good news is that for prepared investors, there’s also significant upside to his projections. Andy is one of the brightest minds I know, so I suggest you check out his just-released research presentation right here.

This Is One of the Few Undervalued Tech Stocks Out There

Alexander Green isn’t an expert on private startup equity, but he does see the value in adding smaller, lower-priced tech stocks to his portfolio.

In fact, his True Value Alert portfolio is made up entirely of undervalued equities. Omnicell (Nasdaq: OMCL) is a recent addition. The company is a pioneer in the field of healthcare automation - and it’s trading on the cheap today.

Here’s Alex explaining the pick earlier this month:

Based in Mountain View, California, Omnicell specializes in medication management systems for hospitals, operating rooms and nursing homes.

Patient safety issues are getting more attention from state and federal regulators. The hospital certification body known as the Joint Commission says that medication errors in the U.S. harm more than 1.5 million patients a year. Several thousand of them die. And the total cost to the nation is estimated at more than $3.5 billion a year.

The Joint Commission is urging hospitals to use tech support to manage medications. And that is playing right into the hands of Omnicell.

The company allows healthcare providers and pharmacies to...

● Ensure safety and efficiency in patient care areas ● Increase pharmacy compliance ● Support accurate IV compounding ● Allow quick access and security in surgical and specialty areas ● Enjoy real-time inventory visibility ● Improve medication adherence in post-acute facilities and at home.

The company is an integrated provider, selling solutions to pharmacists, hospitals and administrators to help the whole healthcare system manage inventory and drug costs.

In recent years, Omnicell has grown through strategic acquisitions, even recently buying a company that does retail pharmacy software for scheduling.

This allows patients to sync their medicines and schedule a single pharmacy trip. When you pick up your drugs, multiple medicines are distributed in individual blister packs so you don’t have to remember if, for instance, you took all five pills on Monday.

Omnicell may not seem particularly attractive with sales down 12% in the most recent quarter. However, that’s only because the company is going through a product transition that’s put a dent in revenue as clients wait for the next generation platform: cabinets with sensors that “phone in” if they need service.

Looking ahead, Omnicell is likely to earn $1.30 a share this year and approximately 65% more next year.

- Samuel Taube with Alexander Green

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