For the past two years, the bulls have had a firm grip on Wall Street. The mature, equity-driven Dow Jones Industrial AverageBenchmark S&P500 (^GSPC -0.20%)and innovation-driven Nasdaq-Composite (^IXIC -0.33%) have all reached multiple record highs this summer.

But as the first three trading sessions of August reminded us, stock price increases rarely, if ever, follow a straight line.

Although growth stocks have undeniably led this rally, it was the Nasdaq Composite that really took a hit earlier this month. Over a three-session period, the index lost nearly 1,400 points, or about 8% of its value. At the close on August 5, the Nasdaq was 13% below its all-time high.

Image source: Getty Images.

Typically, stock market corrections provide long-term investors with an opportunity to initiate positions or increase their holdings in great companies at a discounted price. But with stocks historically expensive, investors (myself included) have become more selective in their purchases.

Since history is not on Wall Street’s side, from a valuation perspective there is only one stock that I took the opportunity to add to during the recent Nasdaq sell-off.

Conditional BuyerInvestors

Before I get into the juicy details of what led me to add to one of my core holdings during the Nasdaq sell-off, I think it’s important to address the reasons why I’m being so selective about buying stocks right now.

In bull markets, it’s not uncommon for investors to pay a premium for growth stocks. In fact, the democratization of information over the past three decades (thanks, internet!), coupled with historically low interest rates for much of the past 15 years, has increased retail investors’ appetite for risk, including buying stocks with outsized price-to-earnings (P/E) ratios.

Sometimes significantly above-average P/E ratios are entirely justified. For example, companies with clearly defined competitive advantages and/or sustainable moats typically achieve higher valuations than their industry peers.

But when looking at the broader market as a whole, elevated valuations are rarely, if ever, a good thing.

S&P 500 Shiller CAPE ratio data by YCharts.

The Shiller price-to-earnings ratio of the S&P 500 is the best example of what happens when stock market valuations deviate too much from historical norms. The Shiller P/E ratio is also known as the cyclically adjusted price-to-earnings ratio (CAPE ratio).

Unlike the traditional P/E ratio, which takes into account the last twelve months of earnings and can be disrupted by one-off events (e.g. COVID-19 lockdowns), the Shiller P/E ratio is based on the last ten years of inflation-adjusted earnings, which helps smooth out “bottlenecks” in corporate earnings.

Looking back to January 1871, the average price-earnings ratio of the S&P 500 (Shiller P/E) is 17.14. On August 19, the Shiller P/E closed above 36 and did not fall much below 33 even during the worst of the sell-off earlier this month.

Including the present, there have been only six occasions in the past 153 years when the Shiller P/E ratio exceeded 30 during a bull market. After the previous five cases, the Dow, S&P 500 and/or Nasdaq Composite ultimately lost between 20% and 89% of their value.

In other words, the Shiller P/E ratio warns investors that stock prices have reached an all-time high – and I’m more of a student of history, which rhymes with Wall Street.

Image source: Getty Images.

This high-growth, capital-rich small-cap stock was my only purchase during the Nasdaq sell-off

Even though the Nasdaq lost double-digit percentages in less than a month, I couldn’t wait to put my money to work – with one exception.

Instead of adding to my Magnificent Seven holdings, I only noticed the stock of an under-the-radar small-cap adtech company during the Nasdaq sell-off PubMatic (PUBM -0.76%).

Although negative market sentiment weighed on PubMatic shares during the first trading sessions in August, it was the company’s second-quarter operating results – and more specifically, its full-year guidance – that drove the price lower.

PubMatic CFO Steve Pantelick highlighted that one of his company’s largest demand-side providers (DSPs) in programmatic ad changed its bidding process in the second quarter. This change will result in slightly lower revenue recognition later in the year. As a result, PubMatic’s full-year revenue guidance is now in the range of $288 million to $292 million, compared to a previous midpoint guidance of $300 million ($296 million to $304 million).

This revenue decline of around 3% on average cost PubMatic more than 30% of its market value, but more importantly, it caused a price shift that was too tempting for me to ignore.

The most important thing to know about PubMatic’s revenue decline is that this will not be a permanent problem, nor was it unexpected. In an interview with Schwab Network following the release of second-quarter results, PubMatic CEO Rajeev Goel pointed out that this major DSP was the last major DSP to make this bid change. Aside from this one customer, the vast majority of PubMatic’s sales channels saw double-digit growth.

Having addressed this headwind that pulled the company’s shares down by over 30%, let’s now look at the many Reasons why sell-side provider (SSP) PubMatic is a brilliant buy.

Let us list the many reasons why PubMatic is a breeze

First, PubMatic is at the center of the advertising industry’s fastest-growing niche: digital advertising. Companies are increasingly shifting their advertising spend from traditional print and billboards to digital channels such as mobile, video and connected TV. PubMatic is ideally positioned to help publishers sell and optimize their digital display space.

PubMatic also faces macroeconomic headwinds. While recessions are a normal and inevitable aspect of the business cycle, history shows us that this cycle is not linear. While three-quarters of all recessions in the U.S. since the end of World War II were resolved in less than a year, the vast majority of economic expansions lasted for several years. Patience tends to be a recipe for success with advertising-driven businesses.

On a more company-specific basis, PubMatic’s biggest advantage may be that the management team did not take the easy route and decided to build a cloud-based programmatic advertising platform. Because the company does not rely on a third-party provider for this platform, the company’s operating margin can scale better compared to other SSPs.

PUBM Cash from Operations (annual) data by YCharts.

In addition, PubMatic is generating positive operating cash flow for the tenth year in a row and is sitting on a mountain of capital. The company ended June with $165.6 million in cash, cash equivalents and marketable securities and no debt. Not only does that cash provide plenty of financial flexibility regardless of what happens with the U.S. economy and on Wall Street, it also allowed the company to repurchase $100 million worth of common stock through July 31. Buying back stock typically has a positive impact on earnings per share, which can make a company more attractive to fundamental investors.

The final piece of the PubMatic puzzle is valuation. While P/E works well for established companies, cash flow is the better valuation metric when analyzing fast-growing companies that are aggressively reinvesting in their platforms.

At the close of trading on August 19, PubMatic shares were valued at 8.3 times Wall Street’s consensus cash flow forecast for 2025. That represents a 38% discount to the cash flow multiple investors paid at the end of 2023.

Additionally, PubMatic’s cash, cash equivalents, and marketable securities represent 24.3% of its market capitalization. If we remove that capital from the equation, PubMatic’s operations are valued at 6.3 times next year’s cash flow, with a sustained double-digit revenue and earnings growth rate. It’s an incredibly cheap stock that I was happy to add to during the Nasdaq sell-off.