Word from Jeff – How to Pick Stocks Now

As the US markets continue to defy gravity in late April and early May, a number of caution flags are briskly waving. For instance, the number of investment pros who believe the market is overvalued is now at something like 90%, and haven assets like gold and low-interest bonds are attracting major cash flows, thought by many observers to signal trouble ahead.  Not that I think these are good buys now, just danger signs flashed by the skittish. Still, as is oft bemoaned, the market can stay irrational longer than you can stay solvent, and the levitation may continue for some – even a long – time. Still, Camarda expects a healthy correction in the short term, but continued strong advances in the long term. We expect the US market to do well, and many non-US markets to do better.

Particularly in a market flirting with overvaluation, bargain hunting for undervalued gems can have wide appeal.  It does not seem possible to overstate the importance of owning the “right” stocks in times like these, and index aficionados should take serious note. For instance, through early April, only ten stocks in the S&P’s mighty 500 were responsible for 50% of the index’s gains. In other words, just 2% of the stocks in the index produced over 50% of the gains. And this is fairly typical, in that the 10 best stocks usually produce around 50% of the gains. Obviously, the other 490 contain a large number of mediocre or worse stocks that index investors are saddled with, or perhaps, kenneled with. Index investing is mechanical and mindless from a stock quality standpoint, and most investors probably don’t realize how many hounds are baying in their cheap index funds. Make no mistake – no one at index funds is screening for good value or strong upside, or any validation of stock price at all. When index funds – and they are huge and powerful – get money, they must buy the whole index, at whatever price, and regardless of valuations. This buying pressure can drive prices up, even to overvalued levels. As index funds increasingly dominate the markets – as they become the markets – there are fewer and fewer smart people doing the research that helps set prices based on attractive value. A recent academic study out of Notre Dame suggests even some 75% of active funds are really stealth index funds, compounding the problem. And the problem is, of course, that index fund values can become increasingly untethered from reality – until the music stops. Another study shows that active management – the kind of stock picking that Camarda does – tends to deliver even better returns in challenging markets, such as corrections and bear markets.

So how to pick stocks now? Look for deep value. Look for stocks trading at a discount to their intrinsic value based on profits, cash flow, assets, and other measures. Invest like Buffett does. He once put it this way: “Long ago, Ben Graham taught me that price is what you pay, but value is what you get. Whether we’re talking about socks or stocks, I like buying quality merchandise when it’s marked down.” Buffett’s cohort Charlie Munger looks at it like this:  “All intelligent investing is value investing – acquiring more than you are paying for. You must value the business in order to value the stock.” Especially now in these overvalued times, we believe this wisdom is the surest path to investment success.

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