One of the most problematic parts of value investing is deciding what to do with a stock that is overvalued. Trying to figure out if you should sell a stock that has run up to new highs and now looks expensive, or whether to buy into a position that looks expensive but could yield some impressive results in the near future is tough. There is no right or wrong answer.
One way to find an answer to this question is to look at the company as if you are the owner or manager. Investors do not have as much information as insiders, but it is still possible to put yourself in a similar position. One way to gauge the current feeling amongst insiders is to watch insider share purchases, which can reveal a lot about where management believes the company is going.
Watch the managers
Management’s actions can tell you more about their view of the stock than anything else. For example, if managers come out and say they believe the company’s stock is undervalued and are therefore initiating a substantial buyback program to jack-up shareholder returns but don’t buy any stock themselves, this can be a strong signal that management is trying to inflate the share price to improve performance -related bonus prospects. If they believe the shares are undervalued, why are not they buying any themselves?
Another situation: if a stock runs up substantially overnight (most likely in the penny stock market) and management decides to use this opportunity to raise funds, increasing dilation and rip off existing shareholders, there is a strong chance management to knows the company will soon run into financial difficulties.
Insider sales are a reliable indicator a company’s stock price may be overvalued and due for a correction.
Wall Street actions are telling
It is not just the actions of insiders that may indicate a stock is overvalued. The actions of Wall Street can also be a reliable indicator. High-profile stocks can quickly become overvalued as a flood of money rushes to take advantage of the opportunity. These hedge fund and Wall Street darlings rarely live up to the high expectations bestowed upon them.
Aside from the actions of insiders and Wall Street, the way of telling if a stock is overvalued or not is, of course, its valuation. When I say valuation, I mean the company’s valuation relative to its own historic figures. I am not talking about relative valuation, which compares the company to its peers. If the whole sector is overvalued, comparing a company to its peers will not reveal anything special. In fact, this approach could end up costing you money as you chase opportunities that appear cheap on the surface but are really extremely expensive compared to the wider market.
There is no shortage of these sort of value traps in the market today. While some companies do deserve to trade at a premium valuation, it is unwise to place too much weight on other businesses' valuations. A premium valuation should be determined by a company’s own projected growth and return on capital fundamentals.
Conclusion
Equity valuation is not a precise science; it is an art. For this reason, it is almost impossible to predict when a stock is over or indeed undervalued accurately.
However, by watching for the above red flags you can increase your chances of being able to pinpoint when a stock becomes overvalued correctly. It is more than likely that the shares will continue to rise for some time after you dump the position, but that is just part of investing. Accurately predicting the market’s next move is impossible and it is a fool’s folly to try. Skewing the odds in your favor by getting out as soon as the warning signs start to flash is the best chance the average investor has of beating the market at its own game.
”‹Disclosure: The author does not own any share mentioned within this article.
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