In a joint appearance with IMF head Christine Lagarde, Federal Reserve chief Janet Yellen announced on Wednesday, May 6, that equity market valuations are “generally quite high” and that there are “potential dangers” with such high share prices. Following an immediate but moderate sell-off, the major indices rose between 0.4% and 0.5% the following day, with nine S&P sectors ending in the black. Between May 6 and the week ending May 15, the Health sector led the rebound with a 3.18% overall increase in value, followed by Technology (2.95%), Industrials (2.52%) and Consumer Staples (2.30%). At this stage, the Fed is concerned that a significant stretching of equity valuations has occurred during the recent unprecedented period of monetary stimulus.

While Yellen’s comments resulted in a negligible impact on US stock markets, the debate as to whether overall market indices are overvalued or fairly valued is not all that significant for the long-term bottom-up investor. It is worth emphasizing that investment opportunities arise in all market situations, regardless of composite indices being historically high or low. Admittedly, it may be more difficult for investors seeking companies that are trading at low valuations to identify such opportunities in bull markets, but they do still exist. Finding these opportunities does, however, require a lot of investment research.

Examples of investment opportunities that continue to arise include those emerging from turnaround situations, where a company is out of favour but management has the ability to increase its value over the long term by implementing strategic and operational initiatives. In other situations, companies of the highest calibre suffer from negative news or temporary setbacks that put an otherwise good organization out of favour, despite retaining much of its true underlying value. Indeed, when aggregate markets are overstretched, undervalued businesses are more likely to be evident as their low multiples tend to stand out compared to their industry peers.

We can’t predict with any certainty when the Fed will raise interest rates. However, when investors interpret the action as imminent, the perceived risk of investing in stocks (and bonds too) will change, given the higher cost of credit. This change in market sentiment will present investors with a tactical opportunity to establish positions in businesses with strong underlying long-term fundamentals. If a sizeable and prolonged sell-off occurs, the opportunity will be even better, as these companies can be bought at more attractive valuations.

It is also worth remembering what has ensued since Yellen made similar comments in July 2014. Back then she identified specific sectors, including social media and biotech, as being “substantially stretched.” At the time, Facebook was trading at $66 – it is now above $78, while LinkedIn is up by 23%. As for the biotech index, it has rallied from 2750 to around 3725, although it did fall by almost 6% in the three days following Yellen’s comments. So yes, interpretation of the Fed’s language does tend to sway markets, but over the longer term other factors will prove to substantiate valuation.

There are sectors in the economy that are likely to improve in the coming months and years if economic fundamentals remain strong. However, a bottom-up approach of investing in specific companies that will perform well regardless of how their sector meanders will allow investors to profit. Right now, the energy sector has a number of companies that are trading at multi-year lows, but they may very well experience gains once the current glut of crude oil is cleared. Over the past 9 weeks (March 13 – May 15), Energy has gained 8.09%, although it did fall by 1.33% in the last week (May 9 – 15). Nonetheless, the sector will be challenged by technological changes in addition to the redistribution of global supply and demand. It is important to be aware of these longer-term changes in analysing stocks for inclusion in investment portfolios.

Moreover, should one adopt a global approach to investing, the opportunity for identifying undervalued businesses will greatly increase. When markets are frothy in one sector or geography, financially attractive targets (FAT) will await elsewhere.

Garnet O. Powell, MBA, CFA

I am honoured to have been able to share with you my thinking on the investment process and would be delighted to hear your thoughts.