25 Real-Life Examples: How High Valuation Can Hurt Investors, Let Me Count the Ways
It almost every article I have ever published, I talk about valuation in one manner or another. So much so, that readers have dubbed me Mr. Valuation. The primary reason I am so obsessed about valuation is because I believe it is one of the most important and yet mostly ignored and overlooked concepts in the investing world. I have been in the investment industry since 1970, and my experience clearly supports this previous statement. Investors focused on stock price movement will throw any consideration of valuation out the window. When a stock is rising it’s a good stock, and if the stock price is falling it’s a bad stock regardless of the underlying fundamental strengths or the valuation of the holding.
What makes valuation so hard for many investors to consider can be easily understood by examining one of the greatest lessons on valuation ever offered. The venerable Ben Graham offered the now famous metaphor as follows: “in the short run the market is a voting machine, but in the long run it is a weighing machine.” What his metaphor is telling us is that the market is emotionally driven in the short run and therefore may not always be reflective of fundamental values. People vote their dollars (purchase or sell stocks) in the short run primarily based on recent price activity. As a result, a stock can have either positive or negative momentum over short periods of time, again, regardless of fundamentals.
The undeniable truth is that human beings are emotional creatures. And as it relates to investing, the primary emotions that investors must deal with are fear and/or greed. When either of these emotions take hold, logic and sound reasoning tends to go out the window. But the most insidious aspect of this short run “voting machine” behavior is that it is totally unpredictable because it is all too often irrational. In my opinion, it is this last point that makes it so difficult for many investors to embrace the important principles of sound valuation. Once a stock enters extended levels of overvaluation, any number of things can happen over the short run, and all of them are unpredictable.
On the other hand, one thing that is predictable is that long-term returns will be greatly diminished by overvaluation. This is an inevitability, however, the precise timing cannot be forecast or calculated. In other words, an overvalued stock can immediately go into a quick freefall or it can go sideways for months or years to come. Additionally, when a stock has short-term “voting machine” momentum, it can continue to rise as it becomes more and more overvalued with each passing day. Unfortunately, there is no way to quantify irrational behavior.