For the past six months, and probably longer than that, investors and the financial media have been asking themselves or have been asked whether the market is overvalued. The market has marched higher and higher and the S&P 500 is now up 29% for the year. There also seems to be signs of a return of ridiculously-priced IPOs, mostly dot coms and bio-tech stocks in my opinion. People have explained why the market is overvalued by citing Schiller's CAPE ratio or that abnormally high profit margins will eventually revert to the mean.

I don't disagree with the fact the market is now a lot higher than it used to be and I'm not afraid to admit this makes me a little worried. However, as an investor and steward of capital, my job is to look for individual, mispriced securities with the goal of achieving above-average returns at below-average levels of risk. Whether the market is over or undervalued is pretty much irrelevant. What is relevant is whether the securities I own (or considering owning) are worth substantially more than the prices at which they are trading.

As for why everyone wants to talk about the market in general is because this is the easiest (and probably the only) thing about which the financial media and amateur investors can talk. Just think about it. The CNBC or Bloomberg interviewer probably does not know a whole lot about the individual companies an investor/interviewee may own, which makes it hard or impossible to generate attention-grabbing quotes or sound-bytes. So the intellectually easy/lazy fallback is to ask about meaningless generalities like the state of the markets. Doing this also allows the interviewer to use numerous and irrelevant anecdotes as filler in their questions to make themselves sound smarter than they are (e.g., Twitter IPO! Quantiative Easing! Obamacare! Bitcoin!).

Alright, so I think discussion about market valuations are useless. Now it's my turn to be a hypocrite and throw in my two cents, which is that I generally agree with the sentiments of Buffett and Malone!

Buffett has said very recently the market and many individual companies are in a zone of reasonableness. I don't know or recall what the basis for his belief is, but I'll bet it might be something like the S&P 500's operating earnings multiple, which is below the median for the last 23 years:

S&P 500 Price to Operating Earnings

The current multiple is definitely not the lowest it's been and it's also not the highest it's been in the past twenty years. We are nowhere near the bubbly years of the dot com bubble or when Coke was trading at >40x earnings.

As for Malone, he mentioned during Liberty Media's most recent investor day he believes subscription-based companies are undervalued due to the low interest rate environment. Now, he was probably talking primarily about the media and content delivery companies, but I believe one can extend Malone's thought process to include almost any company that has some degree of customer captivity along with a steady and growing stream of recurring or highly predictable revenues. 

I believe one such company is TransDigm (TDG), where over 50% of revenues and over 75% of EBITDA comes from the aftermarket:

FY 2013 Fourth Quarter TransDigm presentation

Another might be Colfax (CFX), a manufacturer of "mission-critical" industrial products company where over 55% of sales come from the aftermarket:

Page 5 of November Colfax presentation

I won't say much about Colfax aside from its association with the Rales brothers and former Danaher executives. Visit The Brooklyn Investor for a quick and dirty overview.

Another very different company where the majority of its revenues are recurring in nature is the software and database giant Oracle (ORCL). I've taken this chart from their annual stockholder presentation:

October 2013 Oracle presentation

My clients and myself currently own Oracle. I made the investment because I believed a company with such dependable revenues and trading at a silly 10% free cash flow yield ought to be worth much more.

In summary, I think it's best to ignore the ongoing banter about market valuations and instead focus on finding companies like the ones mentioned in this post that have a large amount of recurring revenues and some customer captivity. Most are likely undervalued (or at least in a zone of reasonableness) given current interest rates and their ability to take on additional debt.


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