Analyzing Stocks On A Curve

by | Investment Basics

I don’t know about you, but I hated being graded on a curve when I was in school. It’s inherently unfair. What really mattered was how I performed. Did I learn the material or not? Being in a class with above average students results in a grade lower than you deserved. Being in a class of below average students might produce higher grades than deserved.

This is how many of us are analyzing stocks. We grade on a curve. I observe this phenomenon throughout the financial industry; including those who are suppose to be “stock analysts”.

I often hear something like this: “ABC company is undervalued because it has a P/E ratio of 18 which is below the market multiple of 21.” That is analyzing stocks on a curve. It too is inherently unfair.

This is a lazy approach to investing that eventually brings pain to every investor who participates. If the stock market is overvalued you might buy stocks you shouldn’t own when you compare metrics to the market.

 

I include this Howard Marks quote in the Key Markets Statistics section of every Arbor Investment Planner Newsletter issue: “It’s essential for investment success that we recognize the condition of the market and decide on our actions accordingly”.

It’s important to know the condition (valuation) of the market. If the market is cheap you will want to own more stocks (equity asset allocation) than when stocks are expensive. If the market is expensive you will want to own less equities.

Each stock should be evaluated on its own, irrespective of the market. Quantitative and qualitative metrics should be employed in your research. You should be asking yourself if you would buy this business at the current price; because that is what you are doing. The best approach to this strategy is to use Enterprise Value.

Related Reading: Enterprise Value (EV) and Calculating Enterprise Value Ratios

This is how you should be thinking about your equity investments: You are purchasing a fractional share of a whole business. You want to buy businesses at a price that offers a margin of safety. If you pay too much for a stock because “the market” is paying too much, then you will suffer below average rates of return.

That doesn’t mean we don’t compare valuations. Obviously, if you are looking at two stocks and one trades at 5 times your metric (i.e. EBITDA) and one trades at 10 times (everything else being equal) of course you would favor the one with the best valuation. My point is to not justify buying expensive stocks because you are analyzing stocks on a curve.

When the market is expensive it will be more difficult to find stocks which meet our requirements. During those time periods we want to hold a larger percentage of cash to 1) preserve capital 2) keep the volatility of your portfolio low, and 3) have plenty of cash to buy bargains when they appear.

Just as grading on a curve in school was inaccurate, analyzing stocks on a curve is inaccurate and dangerous. Try to recognize when others (media, stockbrokers, etc.) are trying to tempt you to buy stocks based on this analysis. It’s a false choice you don’t have to make.

“No, I’ll wait until the odds are heavily in my favor” is the better choice!

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Disclaimer
While Arbor Investment Planner has used reasonable efforts to obtain information from reliable sources, we make no representations or warranties as to the accuracy, reliability, or completeness of third-party information presented herein. The sole purpose of this analysis is information. Nothing presented herein is, or is intended to constitute investment advice. Consult your financial advisor before making investment decisions.

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