Behind the Ugly Red Door: Finding Value in an Overpriced Market

in Stock Analysis

I am about to write a quarterly letter to clients, telling them that despite all the giddiness in the stock market, we are in Value Investor Second Hell. This is not the first hell; that one is reserved for value traps — stocks that look cheap based on past earnings but whose earnings are about to disappear, whereupon the stocks will permanently decline.

The second hell is when you cannot find value. I recently read a study that said the difference in valuation between the cheapest stocks (the lowest 10 percent of the market) and the rest of the market is the smallest it has been in more than 20 years. Of course, the market overall is very pricey; finding undervalued stocks in this environment has become increasingly difficult.

To adapt, you need to understand that there are two types of value stocks. The first are statistically cheap — their cheapness stares you in the face. This breed is quickly becoming scarce; even Hewlett-Packard Co. and Xerox Corp. are now found in growth investors’ portfolios. But before I talk about the second type of value stocks, let me tell you how my wife and I bought our house.

It was 2005. The housing market in Denver, just as in the rest of the U.S., was getting bubbly. Our family was about to grow, though we did not know it yet. We had sold our condo and were renting month to month and thus were under no pressure to buy a house, but we were keeping our eyes peeled for the right one at the right price. It was a nine-month journey. We even made some offers (usually below the asking price), which the sellers laughed at. They were right; their houses sold above the asking prices in just a few days.

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