Tuesday, November 1, 2011

The Perils of High-P/E Investing

It's always difficult to predict when a speculative stock's valuation will come back down to earth. Once a stock has an extreme valuation the time it takes for economic gravity to kick can, more than occasionally, be measured in years.

From this article on GuruFocus:

The fact that the valuations of certain companies can hold their sky-high multiples for an extended period gives the investor the illusion of safety; nothing could be further from the truth.

The article goes on to equate the practice to...

...performing a high-wire act without a safety net. The fact that the performer has navigated the wire successfully a thousand times does not remove the element of risk from his performance.

What seems an obviously overvalued stock will often just get more overvalued. So, on the surface, it would seem there's plenty of time to play the speculative game. Many actually try to time getting out before the other speculators head for the door. Some succeed, most don't, but either way the winner is the croupier.

For me, the highflyers always fall into the category of avoid.

Occasionally, a high flying stock will actually justify what seemed like an inflated valuation. In that case, the investor took a huge risk over time by buying at an inflated earnings multiple, in the long run turned out to be right, and ended up making some money but not necessarily enough to compensate for the risks taken. In other words, too much risk for too modest a reward.

Yes, and at times an exceptional situation comes along that completely justifies the earnings multiple and then some.

Still, much of the time, if you play in the inflated P/E arena, most of the time you'd better get the trading right or you'll lose. In any case, if you pay an extremely high multiple for a stock, huge risks of permanent capital loss are being taken compared to the potential rewards. It's a game where the odds are against the participants but if you can control for those losses it may work out.

So, at least for me, there's too much risk of permanent loss of capital. The above article refers to a quote from Seth Klarman:

"People who chase growth, who chase highfliers, inevitably lose because they paid a premium price." - Seth Klarman

When you avoid the big losses in investing, the gains take care of themselves. 

Instead of buying the highflyers, the risk of permanent capital loss can be reduced substantially if a business with sound economics is bought at a nice discount to intrinsic value. The favorable long-term returns are driven by the core proven economics of the business and, the fact a discount to value was paid, there's more downside protection if a misjudgment is made and things go materially wrong.

No timing or trading skills required. In this situation, a stock that happens to go down from the price paid is not a problem for the long-term investor.

The core economics will still drive your returns over the long run even if what you see as far as the near term stock quotes go gets a bit ugly.

In fact, as a long-term owner, the even cheaper stock will just serve to enhance returns via buybacks.

Adam
 
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