Are Stocks Unusually Overvalued Right Now?

There's no debating that plenty of top stocks, particularly high-growth stocks, have taken a severe beating in recent months. Even so, there's debate among investors as to whether some steep valuations are worth it or how much runway historically high-growth companies have left to pursue.

In this segment of Backstage Pass, recorded on Jan. 5, Fool contributors Jason Hall and Rachel Warren discuss how investors should approach stock valuations and portfolio growth in the current market environment. 

Jason Hall: I'm a little bit of two minds on this. I think there is some reality of the idea that there are a lot of overvalued stocks but I'm also one of those guys that like, I always think there's a lot of overvalued stocks for at least over the past dozen years or so, but for a lot of reasons.

I think if you think about it being overvalued and then maybe invert that and think, why are these stocks trading for a higher multiple? Why they're trading for a higher premium? I think it's easy just to ignore the reality.

That a lot of very big companies are far more profitable, they have better operating margins, they have better cash margins. Every way that you want to measure their earnings power, it's better than the biggest, most profitable companies were 10, 20, 30, 40, 50, 80 years ago.

There's just been a massive swing in the way these companies leveraged technology to be more, like think about Microsoft.

This is a company where I feel is worth couple of billion dollars now, I'm sure it's more now, but are trillion dollars, I should say.

Rachel Warren: Trillion, yeah. [laughs]

Hall: But it generally has margins in the mid-70% range in gross margins. It's operating margins are very high. Is it the second most profitable company behind Apple? I know it's close.

Warren: I believe it is.

Hall: It's one of the five most profitable companies in the world. If you were to look at any other period of time, you're not going to see a company. It's the one of the five most profitable companies in the world that has those kinds of margins. It just doesn't happen.

You get these weird times with the oil industry where the ExxonMobil's of the world were very profitable because oil prices were high. But they have no sustainable competitive advantage to keep that there.

I think it's easy to forget that you have companies like that that are trading for these high valuations for a reason. I try to wrap my head around that. I don't want to say this time it's different because it's not but we value companies based on how profitable they are over time.

How profitable can a company be, and I want to own a share of that profitability. That's a lot of what's happening with a company like Apple.

They trade for a fairly high valuation for a company that size. It's like 7% of the S&P 500 now; by market cap, it's enormous. But it's also the most profitable company in the world.

We've never seen these margins from what is essentially a very powerful consumer brand now. That's really what Apple is and people buy it because they make amazing products.

But they figured out all the supply chain stuff really, really well to squeeze the manufacturers that they use so they take the vast majority of the profits home and they let all the operators that are building all the stuff for them just scrape by on whatever is left over. All that to say, yeah there's a bunch of overvalued stocks.

A lot of them are probably going to stay overvalued as long as they continue to execute. They continue to do well. The big caveat, interest rates probably going to start going up, cost of capital starts going up. That affects profitability for companies that need capital.

That's basically everybody but Microsoft and Apple [laughs] and Amazon and a few others, these tech companies that have these massive multi-billion-dollar piles of cash.

But I don't know. I know I'm rambling here, but the more I think about it, the more it reminds me that we have to move beyond that.

Stocks are a tool, and they are a tool to, I think it was Warren Buffett that said it, that it's a transfer of wealth from the greedy to the patient or something, I can't remember exactly what it is.

But the idea is that all you have to do is extend your holding period for stocks and every year you add by an order of magnitude, you improve the probability that you are going to make money.

It's that damn simple. I'm not thinking about the next year as much. As a buyer I am, the market gives me opportunities, but I'm thinking about when I need the money from my investments.

When I retire, that's like 15-20 years. My kid's going to go to college in like 15 years. That means that I have a great time arbitrage to turn other people's impatience with the market into profits for me.

I think it's an opportunity. That's the way I think about it right now.

Warren: Excellent. I agree. I think everyone's timeline is different too.

If you are a little closer to retirement, you might be looking at adjusting some aspects of your portfolio a little differently than if you have--

Hall: Absolutely. If you're retiring this year or next year or you have a kid going to college and you're 100% in stocks and you don't have a massive portfolio, you're wrong. That's the bottom line.