A stock market bubble is by no means a new phenomenon. Looking back at the track record of global equity markets shows that there has always been a cycle that includes periods of growth and periods of decline.

The recent stock market rally could cause investors to consider whether a crash is now imminent. However, such events can be very difficult to predict.

As such, a strategy that aims to buy undervalued shares for the long run where they are available could be a logical approach. It may allow for strong growth in the long run, as well as some relative protection from a potential market crash.

Predicting if a stock market bubble will burst

Despite the recent stock market rally, identifying a stock market bubble that is ready to bust can be a challenging task. After all, there appear to be some companies that continue to trade at low prices even after the recent recovery. For example, sectors such as financial services, retail and resources could contain companies that have low valuations as a result of weak investor sentiment and an uncertain economic outlook. This could mean there are still buying opportunities on offer.

Furthermore, the stock market’s performance is very difficult to accurately predict. Certainly, it has a long track record of delivering high single-digit annual total returns. However, those returns are very unlikely to be linear. They include periods of growth and decline that themselves are dependent on a wide spectrum of factors that are tough to forecast on a consistent basis. This could mean that a stock market bubble increases in size, or bursts, in future.

A logical approach after a stock market rally

Given the difficulties in predicting whether a stock market bubble will burst or not, it may be prudent to instead focus on purchasing undervalued shares. They may offer a combination of low prices and high-quality fundamentals, such as strong balance sheets and resilient cash flow.

Not only may they be less impacted by a stock market crash because they are priced at low levels, they could outperform their sector peers in a bull market or bear market. For example, a high-quality business with a wide economic moat may have more resilient sales in a downturn. Equally, it may be able to generate higher margins and profit growth that is reflected in a faster-rising share price during a period of stock market gains.

A long-term view

Clearly, no company is guaranteed to escape the bursting of a stock market bubble. Falling share prices can lead to deteriorating investor sentiment that pulls down even the most attractive stocks.

However, stronger businesses purchased at appealing prices can be a sound means of generating impressive total returns. When held for the long run, they could offer relatively strong performance compared to sector peers and the wider stock market.

The post Is the Stock Market Bubble Set to Burst? appeared first on The Motley Fool Canada.

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Through focusing on their quality and future prospects, an investor can realistically build an attractive portfolio of income shares. On a relative basis, it could deliver high returns in a low interest rate environment.

Cheap dividend stocks may still be available

While the recent stock market rally has pushed many share valuations to higher levels, some sectors remain modestly valued in comparison. Within them it may be possible to buy cheap dividend stocks, since bullish investors may have turned their attention to other industries that apparently offer higher growth rates at the present time.

For example, a number of strong businesses in the retail and consumer goods sectors appear to have bright long-term outlooks. Moreover, they seem to have the financial means to overcome future risks from a challenging economic outlook to produce a rising dividend payout for investors. Due to weak investor sentiment at the present time, they could offer the potential to generate impressive total returns in the coming years.

Focusing on the quality of income shares

Of course, not every cheap dividend stock could be worth buying at the present time. The world economy has experienced one of its biggest ever shocks in recent months. As such, high dividends from previous years may fail to be paid in future. Similarly, some companies may struggle to survive difficult operating conditions should they have large debts or weak cash flow.

Therefore, it is important to check the quality of any stock before buying it. This can mean taking steps such as reading its latest investor updates, assessing its strategy, and analysing recent annual reports. Doing so allows an investor to build a picture of the company in question so they avoid potentially unattractive investments. Moreover, they may be able to find the strongest businesses that trade at the lowest prices. They could prove to be the most appealing cheap dividend stocks to buy at the present time.

Considering the relative appeal of dividend shares

While cheap dividend stocks may be less prevalent than they were several months ago due to the stock market rally, their relative appeal appears to be high. The world is currently operating in a low interest rate environment that could persist for a number of months, or even years.

Therefore, relying on other income-producing assets to generate a passive income may prove to be a disappointing move. By contrast, the return potential from dividend shares that trade at low prices could be highly attractive from a long-term standpoint.

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In many cases, they offer high dividend yields versus other assets. They may also be able to deliver dividend growth, as well as capital growth, as the world economy likely recovers from its present woes.

As such, now could be the right time to buy a diverse range of income shares and hold them over the long run.

A generous passive income from shares

Even though many shares now trade at significantly higher prices than they did following the 2020 market crash, a number of companies offer high yields relative to other assets. Certainly, a low interest rate environment makes this task easier for equities. However, some stocks have dividend yields at the present time that are higher than their historic averages. This suggests that they could offer an attractive income stream over the long run.

Of course, there is never any guarantee that a company will maintain recent dividend payouts in future. A whole host of challenges can crop up that causes them to reduce or even cancel shareholder payouts. However, by purchasing a wide range of dividend shares with high yields, it may be possible to build a resilient and generous passive income stream at the present time.

Dividend growth opportunities

As well as high yields, a number of shares could offer a growing passive income in the coming years. The world economy has always recovered from its declines to post positive growth in the past. Although the same outcome can never be assumed, the scale of monetary policy stimulus already announced suggests that a return to growth is likely to be ahead.

Through buying companies with affordable dividends and the potential to deliver rising profitability in the coming years, it is possible to obtain a growing income return. This may become increasingly important over time, since low interest rates and quantitative easing in some major economies could spark a period of higher inflation in the long run.

Capital growth opportunities

As well as the potential for a high and growing passive income, dividend shares could deliver capital growth in the coming years. They could experience high demand as a result of limited opportunities to make a worthwhile income in other mainstream assets. This may drive their prices higher.

Furthermore, a high yield can indicate that a stock offers good value for money and a wide margin of safety. Buying undervalued shares has been a relatively sound means of capitalising on the stock market’s long-term growth potential. As such, now may be the right time to buy dividend shares, since they could produce higher total returns than the wider stock market over the long run.

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Even after the recent stock market rally, there could be opportunities to buy undervalued stocks. They may offer greater scope for capital growth in a stock market rise, as well as more stable performance should there be another stock market crash in future.

Warren Buffett’s focus on undervalued shares

As a value investor, Warren Buffett has always sought to buy undervalued shares. This does not necessarily mean that he purchases companies trading at cheap prices. Instead, he aims to buy a high-quality business for less than he believes it is worth. Sometimes, this can mean paying a higher price than sector peers are currently trading at. However, should the company in question have attributes such as a wide economic moat, Buffett has often purchased it in the past.

The result of this strategy has been very successful for Buffett. He has outperformed the wider stock market over a period of many years. Following a similar strategy could be worthwhile, since it may allow an investor to generate relatively high returns. After all, a stock that is priced for less than it is worth may be able to deliver stronger capital gains versus fairly priced or overpriced shares.

The potential for a stock market crash

Warren Buffett’s strategy of buying undervalued shares could also be appealing due to the potential for a stock market crash. Predicting when this will occur may be challenging. However, through buying companies that do not trade on excessively high valuations, it may be possible to outperform the wider market in a downturn.

Clearly, this does not mean that losses will be avoided. After all, no stock is guaranteed to produce positive returns over any time period – even if it seems to be undervalued when bought. However, it can mean that an investor’s portfolio which is focused on undervalued shares is less negatively impacted by weak investor sentiment and falling stock prices. Such companies may already trade at discounts to their intrinsic values, while overpriced shares decline to their real worth.

Opportunities to buy undervalued shares today

There may be opportunities to follow Warren Buffett’s strategy in today’s stock market. A number of stocks and sectors are yet to fully recover from the 2020 stock market crash.

Certainly, some industries are trading at high prices and global stock markets have hit record highs of late. However, sectors such as retail and consumer goods could contain undervalued shares that represent buying opportunities. Through capitalising on them, it may be possible to earn attractive total returns in the coming years.

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This allows his holdings to deliver on their growth potential. It also means that he does not become overly excited following periods of impressive capital returns.

This approach may be especially useful in today’s stock market environment. The recent rally makes it easier to become overly confident in the prospects for equity markets, which may lead to poor decision-making.

Warren Buffett’s long-term focus

Many of Warren Buffett’s major portfolio holdings have been present for decades, rather than years. In that time, they have often delivered strategy changes and capitalised on growth opportunities that are simply not possible to achieve in a matter of months. Through allowing them the time they need to produce improving returns and higher profitability, Buffett has been able to enjoy higher returns than may have been possible if he had adopted a short time horizon.

This point is especially relevant right now. Many investors may have enjoyed strong returns from their portfolio holdings in recent months. The stock market has experienced a rally that has pushed it to a new record high on a global basis. While it may now be tempting to sell stocks that have produced strong returns, and to buy others in their place, providing them with the time they need to deliver on their strategies could be a more logical approach.

Buffett’s investment fundamentals

Of course, Warren Buffett’s value investing approach means that he is likely to sell a stock if it becomes overpriced. Similarly, if there are other more attractive opportunities available then it can be worth offloading a stock to generate sufficient capital to take advantage of it. Therefore, a long-term approach may not always be the right move.

However, selling stocks because they have risen quickly in price over a short time period may not be a prudent move. It can lead to an investor missing out on future gains – especially since global economic forecasts are generally positive at the present time. And, since the world economy has always recovered from its declines to post impressive turnarounds, there may be further opportunities for capital gains in the coming years.

A simple strategy

Clearly, Warren Buffett’s long-term approach may not prove to be the right one for every investor. As 2020 showed, a stock market crash can take place at any time and can wipe large profits from existing holdings.

However, through having a long-term viewpoint, it may be easier to spot potential mispricings among high-quality stocks. It may also provide greater scope to benefit from the impact of compounding in a likely period of long-term economic growth over the coming years. As such, sticking with high-quality companies even after potential recent gains could be a shrewd move.

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Of course, such a scenario is by no means guaranteed. Some cheap stocks may fail to bounce back from their present woes.

However, a likely economic recovery and low share prices for some high-quality businesses suggest that now could be a sound moment to buy a diverse range of undervalued stocks.

High-quality companies with dirt-cheap shares

Some dirt-cheap shares deserve their low prices at the present time. For example, they may have strategies that cannot be easily adapted to a rapidly-changing world economy. Or, they could have weak financial positions that do not allow them to invest where necessary to become more competitive.

However, in other cases, today’s cheap stocks could offer good value for money. Certainly, some companies face challenging futures caused by economic woes. However, they may have access to large amounts of liquidity to strengthen their financial prospects. Equally, they could have a long track record of recovering from similar scenarios. Therefore, their valuations may not fully reflect their capacity to deliver improving financial performances in the coming years.

A track record of recovery

Predicting how dirt-cheap shares will perform in future is extremely challenging. After all, the future is always a known unknown. However, the past performance of the economy suggests that improving operating conditions are likely to be ahead. After all, no economic downturn has ever lasted in perpetuity. This suggests that many of today’s cheap stocks could enjoy higher demand for their products and services in future.

Moreover, the scale of monetary policy stimulus announced during the coronavirus pandemic indicates that a brighter economic outlook could be ahead. As vaccine rollouts continue and lockdowns fade, consumer spending and economic growth could react positively. This may mean that many of today’s dirt-cheap shares may benefit from a return to normality over the coming months and years.

Buying undervalued shares

Clearly, not all dirt-cheap shares will recover from their low price levels. Therefore, it is important to be selective about the companies that are added to a portfolio. This can mean avoiding those businesses that have less financial stability, or that operate in industries that may become increasingly obsolete in the coming years.

While a stock market rally may have taken place, not all companies have surged in price over recent months. Through buying cheaper businesses and holding them for the long run, it may be possible to enjoy greater scope for capital returns as a likely economic recovery replaces recent difficulties to provide improved operating conditions.

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Although following their strategies may not guarantee high returns, it could have a positive impact on an investor’s portfolio in the long run.

As such, by focusing on industries that an investor understands, looking beyond short-term market movements and holding some cash, it may be possible to earn relatively attractive returns from equities.

Warren Buffett and Charlie Munger’s limited knowledge

Despite their track record of high returns, Warren Buffett and Charlie Munger do not invest in every industry available to them. In fact, many of their most successful investments over the years have been in the consumer goods and banking sectors. They have often overlooked technology businesses, as well as other sectors that many investors have profited from.

The main reason for this is that Buffett and Munger prefer to focus their capital in sectors that they fully understand and where they may have a competitive advantage versus other investors. This may reduce the risk of their investments, since they fully comprehend the potential threats that may be ahead. Similarly, it may mean higher return potential because they are able to identify the most appealing investments in an industry at a given point in time.

Although following a similar approach means that an investor may miss out on some attractive buying opportunities, the success of Warren Buffett and Charlie Munger shows that investors do not necessarily need to be experts in all industries to outperform the stock market.

Looking beyond short-term market movements

Warren Buffett and Charlie Munger also look beyond short-term market movements when investing. This allows them to avoid becoming too fearful in a market downturn, which enables them to buy stocks when other investors are selling them. Equally, in a bull market they rarely become excited about a stock market rally. This helps them to avoid overpaying for shares when other investors are allowing their optimism to cloud their judgment.

By taking a long-term view, it is possible to more easily capitalise on the stock market cycle. It shows that gains and losses for the market have never previously lasted in perpetuity. By understanding this cycle, and seeking to profit from it, it may be possible to earn higher returns in the long run.

Holding cash

Warren Buffett and Charlie Munger also hold relatively large amounts of cash at all times. They do not rely on its returns, but rather use it to be able to respond quickly to short-term market movements that can create temporary buying opportunities. Holding some cash may also provide peace of mind during uncertain periods.

As the 2020 market crash showed, stock markets can recover quickly from their downturns. Through being in a position to react quickly, it may be easier to take advantage of short-term mispricings.

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However, a number of income shares continue to offer attractive yields. They may also deliver rising dividend payouts over the coming years.

As such, now could be the right time to buy a diverse range of dividend stocks. Over the long run, they could produce a generous income return on a relative basis.

Challenges when obtaining a passive income

Many investors may be tempted to turn to dividend shares at the present time to make a passive income. After all, low interest rates available on other assets may push them towards equity markets.

The problem, though, is that the recent stock market rally has caused many shares to have lower yields than a handful of months ago. When coupled with an uncertain economic outlook that could have a negative impact on shareholder payout growth rates, the outlook for dividend investors may seem to be somewhat downbeat.

Focusing on overlooked dividend shares

Despite these factors, a number of companies continue to offer relatively high yields at the present time. Certainly, there has been a stock market rally. But not all sectors or companies have risen in line with the wider market. Some industries and businesses continue to be overlooked by investors, perhaps due to more modest earnings growth rates in a bull market, which could mean they offer good value for money.

Buying such businesses may be a sound move for passive income investors. They may be able to buy solid dividend-paying stocks that are able to grow their shareholder payouts in the coming years. Such companies may be unpopular because they have a less exciting business model than other shares that has failed to engage investors to the same extent.

Diversifying to build an income portfolio

As mentioned, an uncertain economic outlook is likely to remain a risk facing passive income investors in the coming months and years. Even the most appealing dividend shares could experience financial difficulties.

Therefore, it is important to build a diverse portfolio that can offer a higher degree of resilience and a more robust income stream than a concentrated group of stocks. Doing so is a cheaper and simpler process than it has been in the past. For example, regular investing services can reduce the cost of single share purchases so that commission represents a smaller proportion of a portfolio’s size. This may make diversifying even easier for smaller investors.

Moreover, many companies have become increasingly diversified in terms of their geographical exposure. This may allow investors to buy domestically listed businesses to generate a passive income that is dependent on the performance on the world economy. This may result in a more robust income return that can benefit from strong growth rates in some regions over the coming years.

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In many cases, they offer high dividend yields versus other assets. They may also be able to deliver dividend growth, as well as capital growth, as the world economy likely recovers from its present woes.

As such, now could be the right time to buy a diverse range of income shares and hold them over the long run.

A generous passive income from shares

Even though many shares now trade at significantly higher prices than they did following the 2020 market crash, a number of companies offer high yields relative to other assets. Certainly, a low interest rate environment makes this task easier for equities. However, some stocks have dividend yields at the present time that are higher than their historic averages. This suggests that they could offer an attractive income stream over the long run.

Of course, there is never any guarantee that a company will maintain recent dividend payouts in future. A whole host of challenges can crop up that causes them to reduce or even cancel shareholder payouts. However, by purchasing a wide range of dividend shares with high yields, it may be possible to build a resilient and generous passive income stream at the present time.

Dividend growth opportunities

As well as high yields, a number of shares could offer a growing passive income in the coming years. The world economy has always recovered from its declines to post positive growth in the past. Although the same outcome can never be assumed, the scale of monetary policy stimulus already announced suggests that a return to growth is likely to be ahead.

Through buying companies with affordable dividends and the potential to deliver rising profitability in the coming years, it is possible to obtain a growing income return. This may become increasingly important over time, since low interest rates and quantitative easing in some major economies could spark a period of higher inflation in the long run.

Capital growth opportunities

As well as the potential for a high and growing passive income, dividend shares could deliver capital growth in the coming years. They could experience high demand as a result of limited opportunities to make a worthwhile income in other mainstream assets. This may drive their prices higher.

Furthermore, a high yield can indicate that a stock offers good value for money and a wide margin of safety. Buying undervalued shares has been a relatively sound means of capitalising on the stock market’s long-term growth potential. As such, now may be the right time to buy dividend shares, since they could produce higher total returns than the wider stock market over the long run.

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Through buying a diverse range of them, it is possible to build a portfolio that can deliver attractive returns over the long run. With many opportunities to buy undervalued shares still available despite the recent stock market rally, now may be the right time to start the process of capitalising on today’s top stocks.

Defining which companies are top shares

Businesses with competitive advantages over their peers may be more likely to be classed as top shares. For example, they may have a unique product that means they can generate higher margins than their rivals. Or, they could have a lower cost base and stronger brand loyalty that lifts their financial performance over the long run.

Similarly, the most appealing shares may be those companies with solid balance sheets and strong cash flow. This point may be especially relevant at the present time, since the outlook for the economy continues to be very uncertain. Financially-sound businesses may be better able to overcome threats to economic growth caused by the coronavirus pandemic.

Meanwhile, top shares may be those companies that have all of the above attributes, but yet trade at low prices. Their low valuations may, for example, be caused by weaker recent performance that can be reversed over the long run. Or, investor sentiment towards their sector could be downbeat. This may present an opportunity to buy high-quality companies trading at low prices.

Building a portfolio of attractive stocks

Once top shares have been identified, building a portfolio of them can be a challenging task. After all, it is tempting to simply focus on a small number of the best ideas that are available at a given point in time. However, this may lead to high company-specific risk that means an investor is very reliant on a small number of holdings for their returns. Through buying a wider range of businesses, it may be possible to reduce overall risks.

Furthermore, holding some cash in case of a stock market crash can be a shrewd move. This does not mean that an investor relies on savings accounts for their returns. Rather, they have a limited amount of cash available so they can add more stocks to their portfolio should appealing opportunities come along in future. This may mean lower returns in the short run, but can provide greater opportunity to capitalise on the stock market cycle when seeking to buy top stocks.

Taking a long-term view

As ever, even top shares can experience periods of disappointment. Therefore, it is important to take a long-term view of any portfolio that contains equities. The track record of the global stock market shows that it can deliver attractive returns relative to other mainstream assets.

The post How I’d Build a Portfolio by Investing in Top Shares Now appeared first on The Motley Fool Canada.

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