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How to Invest When the Market Is Fairly Valued

Morningstar's Matt Coffina explains why a fairly valued stock should outperform both cash and bonds over the long run

Matthew Coffina, CFA 4 April, 2013 | 6:11PM

What a start to the year! In the first quarter, the S&P 500 returned 10.6% including dividends, closing at a record high, while the FTSE 100 gained 8.7% and hit its highest level since late 2007. While there is a certain satisfaction in seeing the value of our stock investments swell, it's not all good news. The strong market is severely limiting investors' opportunity set. No doubt there are more than a few investors who were scared out of stocks during the financial crisis and have been left behind by this bull market--which is now entering its fifth year.

A fairly valued stock should increase in intrinsic value by somewhere in the region of 10% per year.

If there's a lesson to be drawn from recent experience, I think it's that we should never let emotion drive our investment decisions. Those who panicked at the bottom are quite possibly stuck with 50% losses. Those who kept their cool and stayed fully invested have been made whole.

Probably the most common question I've received lately from readers of Morningstar StockInvestor is some variation of "what should I do in this environment?" In an ideal world, there would always be plenty of stocks trading below our fair value estimates to invest in, and also plenty of companies with Morningstar Ratings for Stocks of 1 star in our portfolios to use as sources of funds. However, the reality is that the opportunities available--both undervalued and overvalued--can vary greatly depending on investors' collective mood.

If you have some cash on the sidelines, your task has only become harder over the past several years. In the heat of the financial crisis in late 2008, more than 850 stocks earned Morningstar's 5 star rating. At the end of March, there were only 26 stocks in our entire coverage universe rated 5 stars.

Still, we have to put our money somewhere. I, for one, greatly prefer a fairly valued high-quality stock to either cash or bonds over the long run--especially with Treasuries and gilts offering a yield less than inflation. To understand why, it is important to know how our fair value estimates work.

Worse Investments Than Stocks
Our analysts assign fair value estimates using discounted cash flow, or DCF, analysis. This valuation technique is based on the idea that companies are worth the sum of their future free cash flows, discounted back to the present at a rate that provides an adequate return to all investors--both creditors and shareholders.

The cost of equity is a key assumption in this process; it represents our analysts' best guess of the return required by shareholders to invest in a common stock. If all of our analysts' forecasts about future cash flows were exactly right (no easy feat, to be sure), I would expect a fairly valued stock to deliver total returns in line with the cost of equity. On average, our fair value estimates should go up by the cost of equity every year, less the dividend yield--as cash is received and future cash flows move closer to the present. If a fair value estimate increases faster than the cost of equity, it means the outlook for future cash flows has improved relative to our original expectations, and vice versa for a fair value estimate that doesn't keep up with the cost of equity.

The most common cost of equity across our coverage universe is 10%--about in line with the long-run returns on US stocks. For a particular company, the cost of equity depends on the level of systematic risk--risk that is correlated with the overall market, and thus can't be eliminated through diversification. We use an 8% cost of equity for companies with unusually low systematic risk (such as diversified pharmaceutical companies or some stable oil and gas pipelines), and a 12% or 14% cost of equity for companies that have above-average systematic risk (such as certain economically-sensitive financial and industrial companies). We add a premium to these base-cost-of-equity levels for some international markets.

My point is, there are worse investments out there than a fairly valued stock. This is especially true if the company has a wide economic moat and a high probability of continuing to compound value for many years. A fairly valued stock should increase in intrinsic value by somewhere in the region of 10% per year. Over 10 years, 10% annual returns will turn £10,000 into £26,000--far better than we could hope for from cash or bonds.

None of this is to say a margin of safety is irrelevant--we still have to protect against the possibility that our analysts' forecasts are too optimistic, or that something unexpected will happen. There are currently 34 Europe-listed stocks rated 4 stars, a much larger group than just the 5 stars (currently only nine European company stocks). Of course, if we are to accept a less-than-ideal margin of safety on any individual stock, diversification is imperative. Most important, we should focus on companies with wide moats and manageable uncertainty (low or medium)--where we can have greater confidence in Morningstar's ability to predict future cash flows.

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About Author

Matthew Coffina, CFA  Matthew Coffina is a stock analyst at Morningstar.