Do valuations matter when investors are making stock market decisions?

While "buy low, sell high" is an investing adage, others caution against trying to catch a falling knife and recommend a "buy high, sell higher" approach. That raises the question: does valuation matter? And if so, when? Can you predict the year's top performers by focusing on cheapness or are sentiment and momentum all that matter in the short term? Does a value-based approach protect you in a bear market? The short answer is that valuation matters – a lot. However, it depends on your timeframe, as various studies show.

Perfect portfolio

Imagine a perfect portfolio, one consisting of the 25 stocks that would perform best over the next year. What do such stocks look like at the beginning of their run? Are they super-cheap high-quality stocks or fuelled by price momentum?

US value investor Patrick O’Shaughnessy ran a profile of “perfect portfolio” stocks since 1963, hoping to identify their common traits. There were none, and the stocks came from across the valuation spectrum.

Cheap stocks outperform over the long term, says O’Shaughnessy, but ignore all those 12-month broker predictions.

“The sad fact is that headline-making high-flying stocks are impossible to identify ahead of time with any degree of consistency.”

Putrid portfolio

What about a putrid portfolio, one consisting of the 25 worst performers over the next 12 months? Here the results are different, with Shaughnessy finding a “clear and strong relationship between valuation and putridity” – almost a third of the worst performers traded at very expensive valuations prior to their dire run.

Some pricy-looking stocks such as Twitter will deliver huge returns, says Shaughnessy, but many more are destined to become market dogs.

“Avoid them entirely rather than trying to pick the few diamonds in the market rough,” he says.

Index returns

If the overall market appears overvalued or undervalued, does it have implications for returns over the next 12 months?

Yes, says Ned Davis Research, having tracked returns following periods where markets were overvalued or undervalued by at least 20 per cent. On average, undervalued indices were 19 per cent higher a year later, while markets dropped by an average of 3.6 per cent 12 months after high valuations.

Five years later, the discrepancy was even more obvious, undervalued indices returning an average of 65 per cent compared to flat returns following high valuation multiples.

Vanguard study

So valuation explains everything, right? Well, no. In fact, many well-known valuation metrics have little correlation with subsequent returns, according to a 2012 study by US index fund giant Vanguard.

Yes, high valuation multiples suggest low future returns, just as low valuations indicate high returns, but this trend has “only been meaningful at long horizons”.

The most accurate metric, it says, is the 10-year cyclically adjusted price-earnings ratio (Cape), as popularised by Nobel-winning economist Robert Shiller. Even Cape, however, only explains about 40 per cent of future returns.

In other words, even the best indicator does not explain the majority of future returns. Valuation can indicate the broad range of future returns, according to Vanguard, but specific forecasts are best avoided, as are any assessments regarding short-term returns.

Cape crusaders

L&G equity strategist

Lars Kreckel

agrees that Cape tells investors little about returns over the next 12 months – the correlation between Cape readings and subsequent 12-month returns is a “paltry” 8 per cent (100 per cent is the maximum). Over 10 years, however, that correlation climbs to 69 per cent, indicating long-term investors should keep a close eye on valuations.

Money manager and author Mebane Faber agrees, noting the S&P 500 has traded at an average Cape of 11 at the start of its best 10-year periods, compared to 23 at the start of its worst periods.

US markets trade at elevated Cape levels today, but other international indices are cheap, says Faber. Globally the cheapest countries have tended to outperform by 4 to 7 per cent annually, with a similar underperformance for the most expensive countries.

Accordingly, investors should buy a basket of the cheapest countries, he argues, rebalancing annually.

Trading on valuation

Acclaimed author, blogger and New

York University

finance professor

Aswath Damodaran

may be known as the dean of valuation, but he says the seemingly rational approach is useless – even dangerous – in certain circumstances.

For example, making judgments about biotech valuations is “fraught with danger”, he says.

There is no point in comparing a biotech company’s current valuation to its historical one, says Damodaran, as its price will be dictated by its drugs pipeline and whether there is obvious blockbuster potential.

Similarly, investors should stop trying to explain social media stock price movements by using traditional valuation metrics, Damodaran arguing rational analysis will tell you nothing about short-term prices.

“If you are a trader, play the pricing game and stop deluding yourself into believing that this is about fundamentals,” he says.

Bear market protection?

Do cheap stocks hold up better in a bear market? Not in the US, says value investor and quantitative analyst

Tobias Carlisle

.

In fact, since 1951, value stocks have tended to fall earlier and faster than the overall US market. They do recover earlier and faster, helping them to comprehensively outperform over time, but investors should remember volatility and drawdowns are “part and parcel of investing”.

What about extremely long bear markets, like in Japan, which remains some 60 per cent below its 1990 peak?

Here, the benefits of value investing are more obvious. Carlisle refers to one study which found that while the overall market turned $1 into only $2.76 between 1980 and 2011, value strategies based on low price-earnings ratios grew $1 into $433.86.

Other common value investing methods, such as choosing stocks with low price-book ratios or high dividend yields, offered similar outperformance.

Even during the 1990-2011 period, when Japanese stocks collapsed, four out of five value investing strategies analysed delivered big returns, ranging from 325 to 1,617 per cent.

Momentum and valuation

“The point is not so much to buy as cheap as possible,” legendary 1920s speculator

Jesse Livermore

once said, “but to buy or sell at the right time.”

Ironically, while data confirms the merits behind the “buy low, sell high” approach, it also backs up the “buy high, sell higher” strategy favoured by momentum investors like Livermore.

Recent winners tend to keep advancing in the short term, just as underperforming stocks usually keep on underperforming. In fact, history shows the annual outperformance of recent winners over recent losers to be even greater than the outperformance of cheap stocks over expensive stocks.

Value investing may seem the polar opposite to momentum investing. However, some strategists, such as high-profile hedge fund manager Clifford Asness, argue investors can profit handsomely by combining the two approaches.

Of course, momentum strategies demand strict exit criteria. Sometimes, investors forget that and get seduced by high-flying bull markets, such as that seen in the late 1990s. At such times, value investing can seem passé.

"There are always people who say that the rules have changed," as Warren Buffett once quipped, "but it only looks that way if the time horizon is too short."