Mark Twain has been credited with saying that “history doesn’t repeat itself, but it often rhymes.” In my experience, this sage observation is particularly fitting when it comes to stock markets and the behaviour of investors.
In the 1960s and 1970s, for example, there was a small group of 50 large-cap stocks on the New York Stock Exchange that were dubbed “the Nifty 50.” These stocks were characterized by consistent earnings growth and sky–high price-to-earnings ratios. For the longest time, this tiny handful of equities were the only game in town for most investors, as they provided reliable growth in share price at a time when most other stocks were languishing. But one day, as all things must, the music stopped, and those seemingly invincible titans fell back down to Earth, scorching investors along the way.
Today, in perhaps an echo of the Nifty 50 era, we’re starting to see investors flock to a similarly small selection of highly valued stocks. In the S&P 500, for instance, the top 10 largest stocks by market capitalization are trading at about 30 times earnings. The other 490 stocks, on the other hand, are only trading at an average of about 16 times earnings. This means that the valuation of the Big 10 stocks is almost double that of the next 490 equities. And it’s only getting worse, with the big guys getting even more expensive while the rest of the market trades at or below historical averages.
Why is this worth noting? Because stocks are a lot like golf scores: the lower the earnings multiple number, the better. So if you wanted to buy one of those big-name stocks today, you’d have to pay almost twice as much per earnings share as virtually any other regular old equity, for a stock that may not even end up outperforming the index average.
Chasing after yesterday’s winners
This is called chasing after yesterday’s winners. For many investors, it can be a tempting approach to take. After all, these stocks already have a proven track record, so why shouldn’t we expect them to just keep on going up forever?
Unfortunately, stocks that dramatically outperform the index over the course of one or a few years often have an annoying habit of looking a whole lot better in the rear-view mirror than they do in the road ahead. When a stock has a meteoric rise, its earnings multiple rises along with it. But that stellar performance, and stock price, can come crashing back down just as quickly.
That’s why yesterday’s winners usually have a hard time holding onto their premium valuations. When the markets are trading above historical averages like they are right now, you might find a better home for your hard-earned dollars in some of the less exciting names that’ve been lagging behind the last few years – especially given the pessimistic tone to a lot of the coverage around equities these days, which means most of the bad news that might come along has likely already been baked into their prices.
Shop for bargains, not headlines
At RBC, for example, our current forecast is for U.S. stocks overall to trade at around 20.2 times earnings in 2023, while Canadian stocks should trade at about 13.7 times earnings. This makes the Canadian market a lot less expensive for prospective investors than the U.S., in large part because we don’t have as many of the big tech names that have had such a huge run–up in both valuation and price.
The same is true for commercial real estate. We’ve all heard about the challenges being faced by owners of commercial office space over the last few years. If you own any shares in a real estate investment trust (or REIT) that primarily invests in office buildings, it likely hasn’t been a pleasant ride.
The good news is, with share prices beaten down, some REITs are trading at significant discounts to the underlying real estate.
Avoid the herd mentality
Now, I’m not for one moment suggesting that anyone should run out and put all their money into these, or any other stocks. What I am saying is that many investors are chasing after a lot of really expensive stocks right now, while completely ignoring a lot of other perfectly good equities that are solid, dull – and on sale at bargain-basement prices.
As Warren Buffet once wrote, you pay a very high price in the stock market for a cheery consensus. At the moment, there’s a great deal of cheery enthusiasm for a small group of very expensive stocks. Smart investors might therefore be wise to look the other way from all the shiny and exciting equities that are in the news every night, and consider a few stocks that are cheap and boring instead.
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This article is for information purposes only. It is not intended to be financial advice, and the opinions expressed are the opinions of the author only. Past performance is not a guarantee of future results. All assumptions, opinions and estimates made by the author are subject to change without notice. Before acting on any recommendations, consider whether they are suitable for your individual circumstances, and seek out professional advice.
This article is supplied by Alan MacDonald, an investment advisor with RBC Dominion Securities Inc. Member–Canadian Investor Protection Fund.
