Buying Stocks When Valuations Are High

Several existing holdings, or companies on my watch-list, are trading at forward-adjusted diluted PE levels above the upper-20s. These companies with lofty valuations, however, have hundreds of thousands and millions of shares trading hands daily. This has me wondering what type of investors are buying stocks when valuations are high.

Before I delve into this, let's look at the 3 approaches investors follow to buy/sell shares in a publicly-traded company. For the most part, investors likely follow one or a combination of these approaches.

Market-Timing Approach

If you follow this approach you are more likely to be buying stocks when valuations are high. Investors who use the Market-Timing approach most likely have no clue what they are doing. In fact, a 'Market-Timing investor' is an oxymoron.

Investors who use this approach focus on how they think the stock market will perform in the short-term. Some employ technical analysis and may try to exploit their hypotheses with the use of derivative instruments or borrowed money. Through luck or skill, some perform well. The vast majority, however, are like deer in headlights and end up performing poorly over time.

Systematic Purchase Approach

Most people are busy and have neither the time, skill, nor inclination to immerse themselves into managing their investments.

Recognizing this, John Clifton 'Jack' Bogle founded The Vanguard Group. Bogle is credited with creating the first index fund. He preached investing versus speculating, long-term patience versus short-term action, and reducing broker fees as much as possible. Bogle viewed a low-cost index fund held over a period of a lifetime with the reinvestment of income and dollar-cost averaging purchases as the ideal way to invest. Essentially, it was a formula-based approach that took many of the best attributes of intelligent investing (ie. a long-term focus, low turnover, diversification, reasonable tax efficiency) and applied them to a list of individual stocks and bonds held in a cost-efficient way.

Warren Buffett's mentor, Ben Graham, developed the checklist of attributes used to construct a “defensive portfolio”. Bogle took this one step further and encouraged people to outsource the work to his firm, which, in turn, outsourced it to investment committees. As long as fees were less than ~1.5% for all services, you might expect to do reasonably well if you stuck with a program and regularly acquired investments through good and bad times.

Ben Graham understood people are typically tempted to 'take action' when they feel the market is unduly high or unduly low. He, therefore, created parameters stating that bonds should not fall below 25% of a targeted asset allocation or rise above 75% for stocks.  If circumstances truly got out of hand, an investor could use systematic sales, new deposits, dividends, and interest to slowly rebalance the portfolio to the new, preferred mix. This strategy relieved the pressure to act while simultaneously improving the odds that a significant failure in judgment did not throw the investor too far off-course.

Before retirement, I participated in my employer's Employee Share Ownership Program (ESOP). A pre-determined percentage of my bi-weekly paycheque was applied toward the purchase of my employer's shares. This 'hands-free' process permitted me to contribute up to 25% of my gross pay to acquire shares.

Valuation Approach

Insiders, executives, experienced business owners, and value investors most often favour this approach.  It requires an understanding of accounting, finance, economics, relevant regulations, and a host of other factors to help the investor gauge an enterprise's true worth.

Under this approach, you typically use a valuation model to determine a fair value at which to acquire shares. This fair value is based on the underlying intrinsic value of the company and is not based on the company's current share price. This reduces the risk of buying stocks when valuations are high.

Some investors who use this approach develop certain areas of knowledge and stick to them. They may build wealth over time by focusing on specific sectors or industries.

I like the Valuation approach because it leads to more sustainable returns and it reduces my risk because I employ a margin of safety. In addition to paying attention to a company's valuation, I seek:

  • to invest for the long-term;
  • extremely low turnover; and
  • optimal tax efficiency.

Investor Behaviour When Stock Prices Are High

A Market-Timing approach 'investor' is apt to sell for no reason other than the expectation that stock prices will fall.

Personally, I do not believe in market-timing. Some might occasionally time the market perfectly but I do not think can be done consistently. The occasional successfully timed share sale is most likely pure luck. For the most part, market-timers are fools and academic evidence supports this.

Someone employing the Systematic Purchase approach will very likely stick with the established systematic purchase schedule.

The Valuation approach investor makes case-by-case, security-by-security investment decisions based on a favourable risk-adjusted net present value of future cash flows.

It certainly becomes more difficult to find attractively valued investment opportunities when there is an element of euphoria amongst the broad investment community. There is, however, a large universe of companies so generally, there will be some companies that are attractively or reasonably valued. Should an investor who employs the Valuation approach be unable to identify any, that investor can let their cash reserves accumulate.

I rarely sell a position unless I need funds for a specific purpose. When I do sell, I consider the tax implication if the security is held in a taxable account. If I sell 2,000 shares for $200/share that I acquired at an average cost of $50/share, I have a $300,000 capital gain on which I incur a tax liability. I might be far better off leaving those shares alone than selling them to deploy funds elsewhere. I essentially have an interest-free loan from the government if I do not sell shares.

Suppose you sell shares that are 20% overvalued and trigger a tax liability. Does this make sense if the company is a great business with good growth potential? Naturally, the decision-making process differs if shares are held in a tax-sheltered account.

Final Thoughts

Buying stocks when valuations are high is nerve-wracking. I wish I could share 'easy rules' to follow but am unable to do so since each company is unique. I look at each company on a case-by-case basis and use management's guidance to help me determine a price at which to acquire shares.

In addition, I spend absolutely NO time monitoring market indexes as they are totally irrelevant to me since I do not invest in broad-market or industry sector ETFs.

Several investors I know have used the Market-Timing approach with disastrous results. Others have built reasonable portfolios by following the Systematic Purchase approach. They used this approach because they had neither the time, inclination, or interest in analysis companies.

I, however, prefer the Valuation approach. I will continue to apply it because I do not want my emotions interfering with how I manage our money. Furthermore, I prefer to use my time to try to identify what I want to buy and at what price.

I wish you much success on your journey to financial freedom.

Thanks for reading!

Note: Please send any feedback, corrections, or questions to [email protected].

Disclaimer: I do not know your circumstances and am not providing individualized advice or recommendations. You should not make any investment decision without conducting your research and due diligence.

I wrote this article myself and it expresses my own opinions. I do not receive compensation for it and have no business relationship with the company mentioned in this article.