Bear markets can be painful to invest through because it seems like no matter what you do, it's the wrong decision. It's in stark contrast to some bull markets (like 2020 or 2021), where literally everything was going up. However, as many stocks have been heavily sold off, it's opened up some incredible investment opportunities.
I've gotten the chance to take advantage of many of these bargains, and I think this was the best thing I could have done during this bear market. Here's why.
Many stocks are trading well below their average valuations
It's no secret that many stocks were absurdly overvalued in 2020 and 2021. These same stocks crashed throughout 2022 and landed at more reasonable levels. However, some stocks sold off well past a reasonable valuation point.
Take Alphabet (GOOG 1.25%), for example. The advertising giant has two entities under its umbrella that own the entire market: The Google search engine and YouTube. Despite its market dominance, the stock sold off tremendously in 2022 due to a revenue growth slowdown caused by advertisement demand weakness.
Now, the stock trades at 20 times free cash flow -- close to the lowest it has been in seven years.
GOOG Price to Free Cash Flow data by YCharts
Each share of Alphabet now controls more of the company's cash flows than ever before, which makes it an enticing investment opportunity. I used the stock's weakness at multiple points to increase my Alphabet position.
MercadoLibre (MELI 1.96%) is in a similar situation to Alphabet.
MELI PS Ratio data by YCharts
Despite the company growing sales at a blistering 61% annual pace, the market values MercadoLibre at a similar price-to-sales ratio as it did during the Great Recession in 2008 and 2009.Investors can purchase this great business at a much cheaper valuation than previously imagined.
Buying these businesses at different low points has worked out exceptionally well for investors, as each has always bounced back and generated excellent returns. As long as the business thesis stays intact, getting into these stocks at low prices is a no-brainer.
Overpaying for a stock can cost investors dearly
So why is buying stocks at a low valuation a crucial part of investing? Let's take a look at an example using MercadoLibre's price-to-sales range. Say three investors buy the stock at three different valuations: One at today's 4.6 times sales, another at the 11.4 average, and the last at 16 times sales. If the stock grows sales by 15% annually for five years, and at the end of the five years it's valued at 11.4 times sales (its average valuation), the returns would look like this:
| Investor | Purchased Valuation | Five Year Return | Compounded Annual Growth Rate |
|---|---|---|---|
| A | 4.6 | 398% | 38% |
| B | 11.4 | 101% | 15% |
| C | 16.0 | 43% | 7% |
Table by Author.
So investor A, who paid a super-cheap price, had an incredible five-year return. The average investor returned precisely what the sales growth rate was, which is still fantastic if the company can continuously grow sales at that pace (which MercadoLibre has for some time). However, the investors who paid a 40% premium to the average valuation had a below-market-average return.
This is why valuation is an essential factor to consider.
Many investors (including myself) made this mistake in 2020 and 2021 by overpaying for stocks that would never live up to their valuations. I'm correcting that mistake now by purchasing robust businesses that are momentarily undervalued. The key word there is robust, as many companies will likely never return to the heights experienced during 2020 and 2021.
Both Alphabet and MercadoLibre still have their best days ahead of them. Still, many other companies are trading at historically low valuations that investors can take advantage of in this bear market.
