The S&P 500 slipped into a bear market in early 2022 as economic uncertainty cast a shadow over Wall Street. The broad-based index regained some momentum this year, climbing more than 20% from its October lows, but it remains about 8.6% below its high. That sparked some debate among investors: Has a new bull market started?
Some say yes. They believe a new bull market began when the S&P 500 rebounded 20% from its bear market lows. Others say no. They believe the index must reach a new high before the next bull market begins.
The precise definition hardly matters. Every bear market eventually ends in a new bull market, and the same outcome is all but guaranteed this time.
So what? Well, the S&P 500 returned an average of 186% during the previous nine bull markets that occurred since 1970. That hints at huge gains on the horizon. Investors hoping to benefit from the next bull should take to heart this investing advice from the Oracle of Omaha, Warren Buffett.
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A great business is not necessarily a great investment
Warren Buffett warned investors to be "fearful when others are greedy, and greedy when others are fearful." That contrarian strategy is based on a quirk of human nature: People tend to overreact to positive and negative information. That means good news can lead to irrational exuberance, and bad news can lead to nonsensical pessimism. As a result, stocks tend to be overvalued during bull markets and undervalued during bear markets.
For that reason, investors should be particularly cognizant of valuation during bull markets and other periods of heightened enthusiasm. A great business purchased at a bad price is a bad investment.
Nvidia (NVDA +1.67%) is a great example. Recent breakthroughs in generative artificial intelligence (AI) have whipped Wall Street into a frenzy over anything to do with AI, and many investors reacted by plowing capital into Nvidia. The stock is up a whopping 186% year to date.
The logic is simple: Nvidia designs chips that are widely regarded as the gold standard in AI infrastructure. The company also extended its ability to monetize AI by branching into subscription software and cloud services, and it will undoubtedly benefit as demand for AI increases in the years ahead. In short, Nvidia is a great business with a bright future.
But shares currently trade at 39 times sales. That's a significant premium to the five-year average of 17.9 times sales. In fact, Nvidia stock has rarely been more expensive at any point in the last decade.
Buy stocks with a competitive advantage
Buffet once said the key to investing is "determining the competitive advantage of any given company and, above all, the durability of that advantage." The term competitive advantage is synonymous with moat -- both refer to the protective qualities that allow a business to maintain or grow its market share.
Competitive moats come in many shapes and sizes, but Morningstar recognizes five distinct sources: network effects, intangible assets, switching costs, cost advantages, and efficient scale.
Network effects occur when new users make a platform more valuable. Amazon (AMZN +0.26%) has long maintained its leadership in e-commerce due in part to a network effect. Each seller creates value for every buyer by bringing more inventory, and each buyer creates value for every seller by bringing more purchasing power. But Amazon benefits from a particularly powerful network effect because it operates the most-visited e-commerce marketplace in the world, meaning merchants have an especially compelling reason to join the platform.
Intangible assets refer to brands, patents, or product qualities that give a company an edge over its peers. Amazon Web Services (AWS) dominates the market for cloud infrastructure and platform services (CIPS) due to certain intangible assets. Specifically, AWS has the greatest breadth and depth of CIPS capabilities of any provider, which hints at an unparalleled capacity for innovation.
Switching costs occur when changing providers is too burdensome. Shopify is the leader in e-commerce software, and its strong market presence is protected by switching costs. Changing vendors would be a big imposition for merchants in terms of time and money.
Cost advantages occur when a company can procure inventory for less or sell products for more than its competitors. Costco Wholesale benefits from cost advantages arising from scale and operational expertise. The company has considerable purchasing power due to its position as the third-largest retailer in the world, but its purchasing power is further increased by its decision to carry far fewer stock-keeping units than other supermarkets. By forcing brands to compete for limited shelf space, Costco can often negotiate lower prices.
Efficient scale refers to situations in which niche markets are best served by a few companies. Waste Management and Republic Services have an effective duopoly in trash collection that arises from efficient scale. Space for landfills is limited, building the facilities is costly, and most markets simply cannot support another competitor.
