In October 2008, Warren Buffett penned an op-ed piece in the New York Times entitled, “Buy American. I Am.” He declared he was buying U.S. stocks for his personal account because stock prices were very attractive, and most major corporations would be setting profit records in 5, 10 and 20 years.
Buffett was right. The S&P 500 has roughly doubled since he published his op-ed. Corporate profits are higher, and investors have warmed to markets again. In fact, you may be wondering if you’ve missed the run in U.S. stocks, or if there’s still time to make money.
Rather than reacting to overall stock prices, look at individual opportunities and ask yourself, “Am I getting more value than I am paying for?” Opportunistic investors should be able to find one-off opportunities in the market, regardless of stock market trends.
To get more value for your money, search for discrepancies between the estimated intrinsic value of a business and the price of that business in the market.
Intrinsic value is defined as the discounted value of the cash that can be taken out of a business during its remaining life. It is a highly subjective figure based on fluctuating estimates of future cash flows and interest rate changes. But it allows you to see past Wall Street’s ongoing obsession with quarterly performance, so you can assess the potential of a business.
How to find mispriced securities
Finding mispriced securities is the key to compounding wealth over time. There are two paths to compounding wealth: closing the discount and intrinsic value growth. The first path can be described as “buy low and sell high,” and the second path is “buy low and let grow.”
Many value investors focus their research on the first path. And indeed, the vast majority of potential opportunities in the stock market are in this category. Though more rare, the second path is potentially more lucrative for wealth creation over time.
The intrinsic value of a company may not be growing, but you may receive good returns when a catalyst or change in market sentiment causes the stock to trade at its underlying value.
A fifty-cent stock that moves to its one-dollar intrinsic value over three, four or five years represents a healthy 26%, 19% or 15% annualized return, respectively. Cheap stocks in this category tend to have poor near-term outlooks and are often disliked by the investment community.
Some well-run, high-growth stocks can often look statistically expensive, but are nevertheless occasionally undervalued and poised to deliver excellent returns. A classic example is Berkshire Hathaway.
Investors assessing the many different businesses of Berkshire Hathaway in 1970, 1980 or 1990 may have seen no unusual value, but they were missing the most important long-term driver of the stock: Buffett’s investment and capital allocation skills. He had invested Berkshire’s incremental cash flow at high rates of return in different businesses.
Why the U.S.?
Beyond the need to be more opportunistic, the U.S. should appeal to Canadian investors for four important reasons:
1. The opportunity set available through U.S. exchanges is vast.
U.S. stock markets are the largest and most transparent in the world. Over half the world’s stock market capitalization can be accessed through the U.S. exchanges. There will almost certainly be some undervalued stocks to own within such a large opportunity set.
2. Familiarity with the U.S. helps Canadians stay the course.
Investors obtain better results when they’re familiar with their holdings. If all you know about a company is its stock symbol, you’re far more likely to sell low when that company hits a speed bump. U.S. familiarity provides Canadian investors with a psychological edge.
3. The U.S. has a culture of innovation.
Hardly any other country celebrates entrepreneurship, risk-taking, innovation and capitalism like the United States.
According to the latest World Bank Survey, the U.S. ranks 4th out of 189 countries for “ease of doing business,” and the three countries ranked ahead of it are tiny (Singapore, Hong Kong and New Zealand). By comparison, Canada ranked 19th. The U.S. has a cultural edge that should continue to be a reliable competitive advantage for American companies.
4. U.S. rule of law and protection of property rights helps investors.
The U.S. has a long history of protecting and enforcing private property rights, which allows companies to risk capital with the confidence that their property rights will be upheld.
In contrast, many fast-growing economies have weaker investor and property rights protections, so emerging markets often trade at low valuation multiples.
Investors who bought the S&P 500 index back in October 2008 did well. Investors did not need any special stock-picking abilities then; just the courage to deploy cash or stay invested.
Although the market is more fully valued today, attractively priced stocks still exist and may be found when their prices are trading below their conservatively estimated intrinsic valuation. You should still buy American stocks, but be more opportunistic.
Felix Narhi, CFA, is a portfolio manager at PenderFund Capital Management, a value-based mutual fund company in Vancouver. He manages the Pender US All Cap Equity Fund.