CA - Finding Value Investments When 'Everything' Is Overpriced

2023-12-19 17:19:35 ET

Summary

• With stocks skyrocketing 16% in 7 weeks on perennial Fed pivot hopes, a patient approach is likely the correct course of action.
• You don't have to chase stocks at sky-high P/E ratios. A market that is capable of going up 20% on air can also do the same to the downside.
• Consider less chaotic investment options such as money market funds, niche dividend stocks, merger arbitrage, and international stocks.

The stock market is a device for transferring money from the impatient to the patient.

-Warren Buffett

Pivot mania has sent stocks skyrocketing over the past few weeks, so much so that even the most dovish members of the Fed are expressing public concern . It's quite possible that the S&P 500 ( SPY ) could exceed its all-time high on algo-driven volume before year-end. It's probably not the humans. Most people that I know in the financial industry are already checked out until the New Year. You should of course be skeptical about huge market moves in either direction in short periods of time, as they tend to be driven more by changes in sentiment or algo trading than changes in earnings. At the current P/E ratio, the rapid price change in the S&P represents about four years profit in the underlying businesses in just a few weeks. Chasing stocks is not attractive here, so what should you do?

Option #1: Do Nothing

If you're sitting on a gain of 5% to 10% this year from being mostly in cash, you have nothing to be ashamed of. Consumer prices have risen about 3.1%, so your real wealth has increased, even when accounting for income taxes. The people bragging the loudest about their massive gains this year will be the same ones panic selling in the next bear market. Vanguard Money Market ( VMFXX ) still pays 5.43% compounded, and if the stock market keeps going crazy, the Fed is more than happy to keep rates right where they are. If you have a Vanguard account you're placed in this fund by default, and it's a better deal than pretty much any bank or CD out there.

I find that investors generally take losses in stride, even large losses. If you buy a speculative stock and it tanks, you can cut your losses and move on. While investors tend to take losses in stride, what drives people absolutely crazy is to make 5-10% when their friends and neighbors are up 300% in speculative stocks. Of course, you never hear a word from these people when they lose everything. Such is the cycle of fear and greed.

Money flows from the impatient to the patient. If you've ever played live poker, you've seen this in action. Loose/wild players usually end up losing everything they came with, though they'll occasionally get lucky and take home thousands of dollars. Stocks melt down periodically. Five years ago today, it was December 2018 and the markets were crashing for no real reason. Apple ( AAPL ) was trading for a split-adjusted $38 per share, or roughly 10x earnings. At the 2021 peak, Apple traded for nearly 40x. That's not rational. Investors assigned absurdly high valuations for stocks like Zoom ( ZM ) during the pandemic and absurdly low valuations for stocks like Exxon Mobil ( XOM ).

As of their last filing, Berkshire Hathaway ( BRK.B ) has $157 billion in cash. If they can be patient and content to earn 5.4% while waiting for opportunities, then so can you. This strategy works because the returns on the underlying businesses beneath the stock market are related to the returns you can earn on cash and bonds. When big valuation gaps are created by fear and greed, you can exploit the difference and profit.

Option #2: Find Niche Dividend Investments

Some of my favorite under-the-radar dividend stocks are preferred shares of financial institutions, paying 6-7% tax-qualified dividends. You need to do a little due diligence to make sure you're not buying trash (hint, preferred shares often have credit ratings). If you are able to assess that there's not much risk to your principal and are okay with liquidity not being great at times of stress, then you're set.

Some of my favorite preferred stocks include Bank of America ( BAC.PR.K ), Morgan Stanley ( MS.PR.A ), and JP Morgan ( JPM.PR.C ). Since they have a par value and fixed cash flows, preferred stocks are great fodder for stock screeners– you can find areas where big investors are dumping and knocking the price down and then scoop up shares on the cheap. A nifty website for this is Preferred Stock Channel , which has custom screens that use software to find preferred stocks trading cheaply. There are also authors on Seeking Alpha that specialize in these types of opportunities. I follow Preferred Stock Trader on Seeking Alpha and appreciate their updates.

Here's what I mean about liquidity creating opportunities to buy low. This is Bank of America preferred stock– you can see that it didn't have any huge moves during the spring banking crisis or from the initial rate surge in August. But then, for no good reason, it went down 10-15% in October (likely because someone was forced to liquidate).

There are all kinds of dividend investments as well. Seeking Alpha runs a stock screener for dividend stocks . If you take a peek at it, you can see that stocks like Coca-Cola ( KO ) and Pepsi ( PEP ) score poorly on measures of value. Alongside obvious stocks like that, you'll find picks like Reinsurance Group of America ( RGA ), and Vici Properties ( VICI ) with better value than the same blue chips everyone else has piled into.

I'm always partial to tobacco stocks as well, the likes of Altria ( MO ), Phillip Morris International ( PM ), and British American Tobacco ( BTI ) all have hefty dividend yields. If you buy a few shares in each and don't reinvest the dividends but just pocket the money, it's hard to lose because over the years you'll pocket more in dividends than your initial investment. The Biden administration is already backtracking on cigarette bans in an effort to help secure the 2024 election, showing the staying power of the world's foremost public-private partnership– the tobacco industry.

Option #3: Merger Arbitrage

With sky-high tech valuations, one strategy you can implement is to buy stocks in companies that are getting acquired, and then hold them until the deal closes. This has been a uniquely effective strategy over the past couple of years, with trades such as Twitter and Activision Blizzard ( ATVI ) making great returns for patient investors. Along similar lines, the trade in the Grayscale Bitcoin Trust ( OTC:GBTC ) looks like it will work out on the end, despite a lot of drama in between. Sometimes M&A deals will drag out, but when this happens you're rewarded for your patience by Uncle Sam– you get long-term capital gains tax treatment when deals get dragged out and you end up having to hold over a year.

So how do you track acquisitions and know when to buy? One clever way to do this is to look at the holdings of the IQ Merger Arbitrage ETF ( MNA ). It's not a great product because it's too passive and carries a 0.77% expense ratio, but you'll see what the big deals are simply by looking at the holdings. It's best to focus on cash deals as a retail investor, as stock mergers tend to introduce volatility into your holdings that you can't easily hedge out as a small trader.

Two deals you might consider getting involved in now are Hawaiian Airlines ( HA ), investing $13.66 to earn $18, and Spirit Airlines ( SAVE ), investing $16.09 to earn about $33-$34. The Spirit case hinges on a court ruling so it's more of a two-way trade (i.e. you can lose bigger), but the Hawaiian Airlines deal appears less contentious.

Because the deal price is fixed on M&A but the market price fluctuates, you can sometimes make similar plays to the preferred stocks, where fast money investors panic and sell and patient investors can come in and buy. GBTC for example traded for a 50% discount to NAV, and Twitter traded for panic prices as well before ultimately closing. If you don't mind taking some risk here, these two airline deals are probably worth a shot. Should market prices fall further, you can double down. For those looking for M&A updates, Chris Demuth Jr. has my favorite merger arbitrage coverage here on Seeking Alpha.

Option #4: Look Abroad

I've been doing business on the Internet for seven years now, and one of the key realizations I had is that my cost of living and income are not connected. You can pay $4,000 per month in rent for one bedroom in Manhattan, or you can live on the beach in Spain for $900. The world is a pretty big place, and if you're willing to go off the beaten path, you can find interesting value for your money.

Well, guess what? Investing is an online business, and most of you reading this have US dollars to spend. You can ski in Austria for cheaper than Colorado (even including the plane ticket over). Most people don't know this and most of those who don't have the time or inclination to fly across the Atlantic. But you can put your US dollars to work buying international stocks and find valuations much cheaper than you would in the US. The same goes for other investors from countries with strong currencies, such as the Nordics and Switzerland. Higher dividend yields and lower valuations are just a few clicks away.

Right now a clever trade you can make is to take your US dollars and use them to buy European or Japanese stocks.

You see how the Yen has gone crazy over the past couple of years? This means Japanese stocks are on sale– as much as 30-40% cheaper than they were a few years ago. Like the other strategies, this tends to work because of a concept called purchasing power parity . When currencies are stronger than they are supposed to be by their PPP, global trade and travel tend to nudge the value back towards fair value in the long run.

Warren Buffett has been loading up , buying Mitsubishi ( OTCPK:MSBHF ), Marubeni ( OTCPK:MARUY ), Itochu ( OTCPK:ITOCF ), Sumitomo ( OTCPK:SSUMF ), and Mitsui ( OTCPK:MITSY ). It's fairly easy to buy foreign stocks from a US account, but you can also consider using ETFs like the Vanguard International Developed Markets ETF ( VEA ), Avantis International Small-Cap Value ( AVDV ), and Vanguard High Dividend Yield International ( VYMI ). US stocks have outperformed dramatically over the past 10 years, but the current strength of the dollar sets the conditions for a nasty reversal over the next 10 years for investors who are overconcentrated in the US.

Bottom Line

Stocks are going crazy to the upside right now. At some point in the future, they'll likely go crazy on the downside. If like me, you're uncomfortable about continually expanding P/E ratios and hype, there are plenty of other ways you can build a diversified strategy that will make money in the financial markets without taking insane long-term risks.

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