I’ve gone off in this space many times on the fact that market valuations are stretched to the max. As a result, forward returns, on average, are likely to be much lower than what we’ve experienced over the past several years.

How much lower?

Well, with the median price-to-sales ratio at 2.5 and nearly three standard deviations above normal, we’re in uncharted territory. If the price-to-sales ratio were just 1.5, then the annualized return is just 2.5%. Using this as a baseline would return not much above the dividend yield on the market.

You don’t need me to tell you that’s a horrible risk-to-reward ratio.

However, overvalued markets can stay overvalued. The reality is that the market is still open for business, and at Hidden Profits we focus on a new stock idea each month.

Here’s how we navigate an overvalued market.

Show Us the Money

I start with a model that over emphasizes the ability of a company to return cash to shareholders via dividends, stock buybacks,  debt reduction, and/or or projects that will generate huge cash flow in the near future in order to reward shareholders through the first three actions.

I call this model “Show us the money.”

The more we can pull out of a company through dividends, buybacks, or return of capital, the lower our risk over time. The performance doesn’t vary much whether the market is fairly valued or overvalued. But when the market is priced dear we run the risk of some nail-biting volatility.

Of course, not every high-yielder is a good investment. Often times the yield is high for a reason, such as the stock price has gotten crushed due to horrible operating performance. The market may even be anticipating a dividend cut. Historically, that’s been a kiss of death for a stock’s performance.

Our forensic accounting metrics also analyze the quality of the company’s revenue recognition, cash flow, earnings quality, and asset quality to reduce the risk of stepping into a yield trap.

Owner-Operator Business

In this environment, I’m very focused on owner-operator businesses. I want companies where the founder or management is heavily invested in the business. Our last three stock selections all have founders still involved in the business today.

They are visionaries. They are rich, and they got rich by operating a business successfully. We just want to ride their coattails. This doesn’t mean that investing in these companies is risk-free. There’s no free lunch on Wall Street. But an owner-operator with a big portion of their wealth tied into the performance of the company helps mitigate some risks.

They have a few eggs in a small basket and they’re watching that basket like a hawk. They’re more likely to respond quickly to changes in the market. Because they’re the Big Kahuna, they have the ability to create change quickly to get the business back on track when it hits a bump in the road.  If management is just a bunch of bean counters with fancy MBAs, I don’t have as much confidence in their ability to navigate turbulent waters.

Variant Perception

If you know what everyone else knows, you’ll get what everyone else gets, which is underperformance.

It’s important to have a viewpoint different than the market. Then, if your analysis proves correct, there’s upside to your investments as the rest of the market catches on and adjusts.

When I say knowing something that others don’t, I do not mean having inside information. Rather, I mean thinking about a company’s prospects differently than the market — in other words,  having a “variant perception.”

The last three selections in Hidden Profits all face big issues or problems. The problems are well known in the market. But our view is that the conventional wisdom with how these companies will overcome their issues and return former glory is all wrong. That there’s potential hidden in places others aren’t looking o don’t quite understand.

If our thesis proves correct, then the upside to our investments is substantially greater than owning the market. We can and will be wrong at times. But, by focusing on companies with good earnings quality, cash flow opportunities, and visionary executives with huge wealth tied to operational performance, we can dramatically put the odds in our favor.

I’m still bringing on new readers at Hidden Profits, and you don’t want to miss out on this next pick.

Till then,

John

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John Del Vecchio
In 2007, John Del Vecchio managed a short only portfolio for Ranger Alternatives, L.P. which was later converted into the AdvisorShares Ranger Equity Bear ETF in 2011. Mr. Del Vecchio also launched an earnings quality index used for the Forensic Accounting ETF. He is the co-author of What's Behind the Numbers? A Guide to Exposing Financial Chicanery and Avoiding Huge Losses in Your Portfolio. Previously, he worked for renowned forensic accountant Dr. Howard Schilit, as well as short seller David Tice.