Investing In A Late Stage Bull Market

There is an old Wall Street adage that says a bull market moves in three stages–in the early stage, only a few perceptive individuals or entities are able to pick out glimmers of prosperity in the future. These are the investors who go on to reap the biggest gains. Then, halfway through a bull market, investors are “starting to come around”, and those investors tend to reap moderate gains. And lastly, everyone becomes excited about investing, and those investors tend to reap the fewest gains as most businesses become priced at a point that all but guarantees mediocre returns.

Of course, investing slogans are all well and good, but the obvious follow-up inquiry is: How are they integrated into an actual lifetime wealth accumulation strategy? My answer is that, when you are participating in an investing environment where every investor seems more optimistic than not, you have to rededicate yourself to studying business fundamentals and only making purchase decisions at prices that make sense.

One way I try to do this is by coming up with my business valuation for a stock before I look at the price price–that way, you can sidestep the trap that high school students fall into when they look at the back of the book for the answer to a problem and then try to reverse-engineer the work they show their professor.

Take, for example, one of my favorite businesses that has ever existed, Pennsylvania water utility York Water (YORW). I would love, love, love to buy a block of this stock and hold it for life. It is one of the most academically and historically satisfying investments that has ever existed. It gives its people water, and has paid out a dividend every year without fail since 1812. If your great great great great great great great granddaddy owned this stock, it could have been passed along father to son over the generations and it would have served as a single action that would have single-handedly altered a family’s fortunes up until the present day if the stock ownership position were retained.

If the conditions were right, I would have no problem wearing my pants up to belly-button and having 35% of my net worth sitting in water utility stocks.

But a clear analysis indicates that those conditions do not exist today. It earns $13.5 million in net profits, or $1.05 per share. Unfortunately, it carries $90 million in debt, which means that earnings are leveraged about seven-fold (the utility average is a little over 5x net profits). It grows profits at around 4-7% per year.

You do not have to be John Templeton to figure out that York Water would be a belly-button deal at around 11x earnings or cheaper, which would be a stock price of $11.55 per share or lower. Its fair value, depending on interest rates, is going to be somewhere in the band of 14-18x earnings. Again, based on those $1.05 per share profits, we are talking about a stock price of between $14.70 per share and $18.90 per share. Even if you were more detailed with your calculations, you are not going too far from those calculations.

Then, after I have calculated what I think the business is worth, I look at the current stock price, which is around $30 per share, allowing for some fluctuation. That is going to be a problem. Analysts only expect York Water to earn $1.60 per share in profits five years from now, which at 18x earnings, would be $28.80 per share. My independent analysis is that York Water is currently trading at 2023 prices. Great business, but at this price, no thanks.

Being precise about valuation will allow you to ride through whatever subsequently comes in the economy because devastating returns are not usually the result of a fairly priced business becoming almost unconscionably cheap, but rather, are the result of a dramatically overpriced business becoming moderately cheap. As a statistician would remind you, it’s all about the delta.

The good news is, as obnoxious as being disciplined about valuation can be, it works. Even though most of my investing life has been less than a decade or so long, and has therefore coincided with a bull market more or less, I’ve only sustained one substantial loss. Otherwise, the consequence of being disciplined is that you miss out on some opportunities trading at a seemingly perpetual high, like Amazon. That does not bother me, because there are plenty of 12-22% annual compounders that trade below 20x earnings at the time of purchase. Reminding yourself that valuation matters, and should not be ignored just because a lot of stocks are trading at higher P/E ratios these days, is the obvious first step to protecting one’s wealth through basic rationality.