Darst and Royce's Kaplan: What high-altitude markets mean for portfolio selection

Independent investment consultant David Darst and Royce Funds portfolio manager Jay Kaplan weigh in on how market valuations are affecting their investment decisions now.

This week on WealthTrack what do high altitude markets mean for portfolio selection. Asset allocation master David Doris and small cap fund champion Jake Kaplan discuss the routes they are taking to stay at peak performance in pricy markets. They are next on Consuelo Mack WealthTrack. [MUSIC] I began the interview by asking Darst about his personal perspective on market valuations. I think we're relatively late in this party, this bull market phase. You've got several indicators of valuation which would tell me that this is not the. If a party goes from six o'clock to midnight. This is not seven or eight o'clock. This is more ten o'clockish or even after that. You got four big long term valuation indicators. One is you've talked about many times the cyclically adjusted price earnings ratio which is the Professor Schiller ratio. Yeah. 50% higher than the normal. Right. 'Kay, in the long-term average. Secondly, you have the market capitalization to GDP ratio. It is double the GDP of the United States right now. It has never been this high, except three times. Before 1929, before 2000, the big crash then, and before, 2000, in 2007 before the crash then. Price to sales is 1.67 times sales. The long term average is half that. It is double the long term average price to sales. You can't mess around with sales like you can with earnings. And finally is the, what's it called, the Tobin Ratio, the Q ratio which is price to replacement cost. It too is very elevated. So on a long term basis, people talk about price to next 12 months earnings. That's fine, it's in the zone. 15, 16 times earnings. But on a long term basis Consuelo, the drivers of asset prices for thousands years are fundamentals and valuation and psychology. And the time to really leave the party is when the psychology gets too ebullient and too optimistic. We're not there yet. This valuation abnormality, this valuation anomaly can continue until people all get pulled into the party. Then it's time to leave the party. Alright. So you're not seeing that yet. No. Jay Kaplan from your advantage point as a portfolio manager of small cap stocks, how does small cap valuations look? Small cap markets, pretty high. It's gone almost straight up since the financial crisis of 2008, 2009, that's a little bit dangerous. So when we think about- A little bit dangerous? Just a little bit dangerous. We think about the Russell 2000. And what constitutes that, there are close to 25% of the companies that don't earn any money. And that makes the valuation look really extreme. So when people think about that market there's a lot of danger lurking within. Things like biotech stocks and internet stocks and social media stocks. So I think care is warranted and at Royce we think about how can we buy good companies and try and minimize any damage from a potential correction. But you know, interest rates are zero still. Close to zero. And. Earnings are growing. The economy is growing slowly. So as long as rates stay close to zero and the economy doesn't go into a recession, the market can keep going up. But, rates will start to go up one of these days if the economy gets better, and then we have to be kind of careful. So, careful. So, what does that mean as far as your investment strategy is concerned at Roys? What do you do in a situation. Where overall, the market is looks pretty pricey. It does look pretty pricey. So we focus on what we think our quality companies with really strong financials companies that are in great returns on capital, and we try to buy them cheap. The problem today is there's not much that's cheap. So as a portfolio manager, what we've done is focused on the highest quality companies. And maybe we'd hold on to them a little longer than we might otherwise. And we'll hold them at higher valuations than we might otherwise. Because the stocks that look really cheap today are really not great quality and they deserve to be cheap. In a normal market there are always bargains. Companies that are mispriced. The mispricings really aren't there now. So instead of digging down to buy cheap stuff that's not of really good quality again. We will hold things and take valuation risk instead of taking business risk. Right, and so valuation risk means that it might be, they might be expensive. They might be. You wouldn't buy them at current levels, but you're not willing to sell them. Because if I sell them, what I would replace them with is probably of much lesser quality. And, I'd rather hold on, Right. to businesses that are really good, that I like. Okay. [MUSIC]

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