The stock market’s performance over the past two years has made me feel a bit like a poker player in a high-stakes game. I’m satisfied with my hand, but there’s enough money on the table to give me pause.
Being jittery about the market is normal. But if you want to invest wisely, you need to determine whether your concerns are grounded in reality before you react to them. For me, that means pulling out a calculator and doing a little math.
What’s making me nervous? Despite the market’s early-2014 swoon, my portfolio, which has been fully invested for less than two years, is up a solid 41%. That’s not because I did anything brilliant. My benchmark—Vanguard Total Stock Market Index (symbol VTSMX), adjusted for when I made purchases—is up almost the same amount, so the Practical Investing portfolio is simply tracking the market. Still, the stock market has returned about 10% annualized over the long run, according to Morningstar’s Ibbotson unit, so the gains we’ve enjoyed for the past two years are exceptionally high.
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Those outsize returns make me wonder whether my stocks, and stocks in general, have become overvalued. If that were the case, I’d want to sell some of my positions and build up cash. So I decided to do a quick analysis of each of the 18 stocks in the portfolio. With most, that meant taking a look at the share price, the stock’s dividend yield, the company’s earnings and the expected growth rate for those profits.
My analysis is based on the simple premise that returns come from two factors: a stock’s dividends and a company’s earnings growth. Thus, my quick-and-dirty approach for determining whether a stock is reasonably valued is to look at its price-earnings ratio and compare it with the sum of a company’s earnings-growth rate and its dividend yield. What I want is a P/E that’s near or less than earnings growth plus yield. It’s only when the P/E far exceeds the growth rate plus yield that I seriously start to consider selling. (The analysis for the real estate investment trusts and the business development company in my portfolio is a little different. But that’s a story for another day.)
To see my system in action, let’s take a look at Seagate Technology (STX), the portfolio’s second-biggest winner, with a 144% return since I bought it a bit shy of two years ago. Despite the surging share price, Seagate still sells for just 10 times estimated earnings for the fiscal year that ends in June (all data are as of January 31). Analysts, on average, expect earnings in the following fiscal year to rise by 11.2%, and the stock boasts a 3.3% dividend yield. The sum of those two figures is 14.5, which is way more than the P/E of 10. So I conclude that Seagate is, at worst, fairly priced, and may even be a bargain.
Sticking with big tech. After reviewing every stock in the portfolio, I felt mostly comforted. A few stocks didn’t quite meet my criteria, but they weren’t wildly out of line. And where the numbers didn’t hold up, I thought I had a compelling reason to hold the shares anyway. Intel (INTC, $25), for example, is retooling to become less dependent on the moribund personal computer business. I have great faith in the company’s long-term future. Microsoft (MSFT) has found a new chief executive to replace Steve Ballmer (his departure is a good thing, in my view), and it has a boatload of cash. In fact, when I factor the cash into the analysis, Microsoft looks really cheap.
Of course, this is a simple analysis, but it deals nicely with the problem of market jitters. It tells me I can be comfortable with my holdings and allows me to go back to living a life that, if not entirely free of jitters, isn’t consumed by them.