The post below is an excerpt from the recent Ensemble Capital quarterly conference call. You can read the full transcript here.

As I mentioned at the beginning of the call, the economic data that was released in the last quarter generally supported the idea that the economic conditions that have been in place for number of years continue to persist. However, what has changed is a broad increase in the market valuation of US stocks. While the S&P 500 has increased in price by 18% since the end of 2014, the earnings of the companies that make up the index are essentially flat. This has led the PE ratio to go from 18 times to over 21 times and has caused many people to worry that the market is overvalued.

At Ensemble, we do not believe that there is an effective methodology for investors to accurately determine if the market as a whole if over or under valued in a way that allows them to act on this information to generate superior returns. Those who think the market is overvalued tend to point out that the current PE of 21 times is more than 30% higher than the average PE of 16 to 17 times that has been observed for the past 60 years. However, valuation is not a static concept. There is no law that says that the average valuation of the past 60 years will be the average valuation over the next 60 years. The fair value PE ratio is a reflection of how much growth potential a company has, how much cash flow a company generates per dollar of earnings and the company’s cost of capital.

While many people believe that growth in the years ahead will be lower than it has been in the past, we can also observe that cash per dollar of earnings has increased over the years for S&P 500 companies as returns on capital have increased, while the cost of capital has fallen with lower interest rates. Since the S&P 500 is made up of a changing mix of companies, it is possible that the companies that make up the S&P 500 today deserve higher PE ratios than the average company that made up the S&P 500 over the past 60 years.

Indeed, while the average PE ratio of the S&P 500 over the past 60 years has been 16 to 17, the average PE over the past 30 years has been 19. So an important question for investors to answer who seek to cite the PE ratio of the market as evidence of that it is over valued is whether it is appropriate to assign as much weight to the average PE ratio of 14 that persisted from the mid 1950s to the mid 1980s as they do to the average PE ratio of 19 that has persisted from the mid 1980s to today.

If the last 30 years is a more valid assessment of the fair valuation of the market than the previous 30 years, then today’s PE of 21 is still slightly above average, but close enough to the average that it is not statistically meaningful. Indeed, the market has traded at PE ratios above 21 in almost half of the past 30 years.

Why might this be the case? Well one large difference between the S&P 500 of today and the index of over 30 years ago is the shift in the largest companies within the index from energy and financial companies, which rightly trade at moderate or even low PE ratios, to technology companies which rightly trade at higher than average PE ratios.

By “rightly” we mean that the leading technology companies of today are growing faster and generate higher returns on capital than did the financial and energy companies of many years ago, and basic valuation math shows that these characteristics confer higher fair value PE ratios.

Now the idea that tech companies deserve high PEs as a way to justify high market level PEs will remind investors with any sense of history of the Dot Com bubble. But the valuation of tech stocks today bears no resemblance to the bubble.

Today, technology stocks trade well below both the average and median PE ratio for tech stocks over the last 30 years and in fact the S&P 500 technology sector trades at a more than 10% discount to the market as a whole.

Instead of high PE ratios for individual tech stocks driving up the market PE ratio, the market cap of technology stocks has become a much bigger component of the market than it was in the past and since technology stocks deservedly trade at higher PE ratios than other sectors, this shift has deservedly increased the average PE of the market as a whole.

No less a value conscious investor than Warren Buffett commented on this shift at the most recent Berkshire Hathaway annual meeting, where he pointed to the fact that the largest companies in the S&P 500; Apple, Microsoft, Amazon, Facebook and Google generate far more cash per dollar of earnings than companies of the past. Buffett even went so far as to say that he’d like the holdings of his portfolio to look more like these companies, a sentiment he certainly never expressed during the Dot Com bubble.

Now none of this means that we think the market is not overvalued. Maybe it is. It just means that there are plausible arguments to be made that the market is fairly valued or even cheap. But at Ensemble Capital, we don’t think that making this determination is possible or necessary. We believe that many companies face so much uncertainty about their future that it is not possible to make a reasonable assessment of what they are worth. So we simply don’t own those companies.

Instead, we limit our holdings to just 15 to 25 companies that we feel we can make a reasonable assessment of their fair value and which currently trade at a discount to that valuation. In any market, even during bubbles, there are always stocks trading at a discount. So long as we only focus on owning those stocks, we don’t think we need to spend much time contemplating whether the market as a whole is over or under valued.

That being said, we do note that today we are finding it more difficult to find high quality, competitively advantaged companies that trade at a discount than we have for a number of years. While portfolios under our management are still relatively fully invested, we rate a larger than average number of positions as Holds rather than Buys. This means that as cash enters our portfolios, either through new deposits or us trimming existing holdings, we are not fully investing the proceeds and so cash levels have begun to build in some cases. But far from being a call on the market, this cash is simply the residual of our decisions on individual stocks. Rather than waiting for a pullback in the market, this cash will be put to work when we complete research identifying new stocks with investment potential or when stocks in our portfolio in which we do not currently have a full position decline to more attractive levels.

While we don’t make investment decisions based on how the market as a whole is trading or even the underlying sectors, we do think it is notable that today approximately 80% of our portfolio holdings are members of the Technology, Industrials and Consumer Discretionary sectors and that each of these sectors are currently trading below their average PE ratios over the past 30 years. While this fact is not the reason why we own these stocks, it does show that the companies in our portfolio are members sectors that are trading at historically cheap valuations, even while the market as a whole is trading at a level above its historical average.

Ensemble Capital’s clients own shares of Apple (AAPL) and Alphabet (GOOGL).

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

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