The market is undervalued but concentrated

During much of the stock rally from the lows of the coronavirus pandemic, a handful of mega-cap stocks led gains. Now some of those same big-name stocks are depressing overall market valuations.

After starting the year in overvalued territory, we believe the market has skewed too far to the downside. Based on a composite of stocks covered by our equity research team, the broad US equity market trades at a 15% discount to our fair value. The most recent instances where markets traded near this discount level were in December 2018, when the market suffered a growth scare, and in March 2020, when markets were reeling from the onset of the coronavirus.

What’s different this time is how much of the undervaluation is skewed by a concentration of significantly undervalued mega-cap stocks: Alphabet (GOOGLE) (AMZN)Microsoft (MSFT)and Meta Platforms (formerly Facebook) (FULL BOARD). So far this year, the price of each stock has fallen more than the general market average, but we remain convinced of the intrinsic value of these companies for long-term investors.

Based on our research and valuation methodology, we believe the market is providing long-term investors with the opportunity to invest in these high-quality, broad growth stocks at valuations that are closer to value stocks and provide a significant margin of safety from its intrinsic value.

One thing we find interesting about the market sell-off is that much of the current undervaluation has been unusually concentrated. If we remove these four undervalued mega-caps from our overall market valuation calculation, our fair value discount to the rest of the US stock market is reduced to 9%. The reason the amount of undervaluation falls so low is that the market capitalization of these four stocks represents 14% of the total market capitalization of the roughly 700 stocks we cover that trade on US exchanges. The market capitalization-weighted average discount to fair value of these four shares is 35%.

Comparatively, if these same four stocks were removed from the calculation in March 2020 and December 2018, there would be very little difference to the broader market valuation. At the time, the market was more broadly undervalued rather than biased by these four stocks. We believe this underscores the current opportunity for long-term investors to invest in these companies.

Price/fair market value ratios with and without the four mega-cap companies

Undervalued mega-caps have less of an impact on sector valuations

The sectors in which these four stocks are included are undervalued in their own right. As such, when you exclude these stocks from sector valuations, those sectors remain significantly undervalued.

For example, at a P/F ratio of 64%, the communications sector is the most undervalued in our coverage. Even after removing both Alphabet and Meta Platforms from our calculation, the fair price/value remains at 65%. Although the market capitalization of these two companies comprises more than half of the sector index, this sector has a large number of deeply undervalued stocks. The median price/fair value of shares in the communications sector is 73%, the lowest of all sectors.

The price/fair value of the consumer cyclical sector is 78%, the next most undervalued sector. The removal of Amazon has a greater impact on the valuation of the sector, as the fair price/value would increase to 88%, but the sector would still be one of the most undervalued.

Technology has been the hardest hit sector so far this year and is now trading at 84% fair price/value. Like communications, the sector is highly undervalued, with Microsoft’s removal from the valuation calculation bringing it down to just 87%.

Price/fair market value ratios with and without the four mega-cap companies

What we expect in the coming months

While we believe the market is currently undervalued, we expect the current volatility to continue over the coming months. This volatility is the result of a confluence of the four main headwinds we identified earlier in the year that investors are now struggling with:

  • Decline in the rate of economic growth in the United States;
  • monetary policy tightening;
  • Inflation is heating up more than expected;
  • Increase in interest rates.

Until there is more clarity on when these headwinds will subside, volatility is likely to remain elevated for months to come.

Investors are caught between fears that earnings and valuations will come under short-term pressure from these headwinds, but they also realize that stock valuations have fallen to levels that have become attractive to long-term investors. term. As such, on days with negative news headlines, market sell-offs have been overdone, while on days with positive headlines, stocks have risen.

In these types of market environments, it is especially important for investors to have an investment plan that balances their long-term investment goals with their tolerance for risk. This plan should also allow for regular rebalancing to increase your capital allocations when valuations drop, but also reduce exposure when valuations get too spread out. Based on our view that the US stock market is undervalued, we believe that now is not the time to reduce exposures, but to increase them judiciously based on your investment plan and objectives.

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