Where Most Investors Stumble

The profound Charlie Munger once said that investors must "Invert. Always invert." In the investment world, things aren't always what they seem -- and investors should never focus only on the obvious.

A book's cover won't tell the full story
Consider the relative valuation metrics of two companies:

Company A

Company B

Price-to-Earnings Ratio

81

33

Price-to-Book Ratio

13

6

Net Margin

24%

25%

ROE

19.5%

21.2%

Debt to Equity

0

0

With these metrics, Company B looks like the better value. We might guess that Company A is a high-flying tech company and that Company B is a medical company or any other strongly performing business.

But appearances can be deceiving. And if you are thinking conventionally, you might assume that Company B is a safer bet for your investing dollars. I've often found conventional wisdom to be long on convention and short on wisdom.

The numbers above are for two very real companies. Company A is Intuitive Surgical (Nasdaq: ISRG  ) , a designer and manufacturer of cutting-edge robotic surgical systems. But Company B isn't some ultra-conservative utility stock. It's none other than search-engine giant Google (Nasdaq: GOOG  ) .

I am not suggesting that Intuitive Surgical is a bargain investment right now. My point is that investors too often limit their reasoning to a few valuation metrics, like the price-to-earnings (P/E) or price-to-book (P/B) ratios. In doing so, they risk missing the boat on truly fantastic investments.

Broaden your approach
Assume for a moment you found  a business that you understood and that offered a wonderful product and had a vast market in which to grow. You like the business fundamentals, and there's no funky accounting or hard-to-value assets. You find that this company had earned $0.24 a share in the most recent year, yet its valuation based on the P/E ratio was high, say 30 to 40 times. Do you immediately reject it? Conventional investors might say it was too expensive and move on to other stock research.

On the other hand, if you invest with a little more rigor and heed Munger's advice, you can find rewarding opportunities that aren't obvious at first glance. Chipotle Mexican Grill (NYSE: CMG  ) earned $0.24 per share in 2004, although it didn't go public until 2006 (for $45 a share). In 2005, the company's EPS was $1.43, implying an initial P/E multiple in the low 30s.

By the end of 2007, though, Chipotle's net earnings came in around $2.13 a share. Put another way, IPO investors paid just 21 times forward earnings for an excellent company that has put in some strong growth in recent years. And anyone who has visited a Chipotle knows that the food is excellent and folks wait in long lines for a taste of the flavorful Mexican fare.

A time to buy, a time to wait
Does mean that at $110 a share and a current P/E above 50, Chipotle still makes a decent investment? At these levels, Chipotle is one expensive burrito. Granted, shares have seen a nice drop since the beginning of the year, and the company could easily earn $5 a share in the next two to three years. I prefer to invest with a larger margin of safety, focusing more on how much I might lose rather than simply counting the Benjamins.

Nonetheless, value investors who ignore high-growth companies miss some of the best values in the market. Businesses such as Chipotle, Amazon.com (Nasdaq: AMZN  ) , Apple (Nasdaq: AAPL  ) , and Whole Foods (NYSE: WFMI  ) won't look like traditional value plays, but when you realize that a big component of value is growth, it turns out that their high initial valuations still represent good value. Buying growth at a rational price can make a shrewd value investment. As the saying goes, "Price is what you pay, value is what you get."

Investors should never base a choice to buy a stock on anticipated results without first determining a fair price to pay for a business. But investors should never dismiss an investment because it fails to meet rigid -- and often arbitrarily limiting -- parameters.

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11/25/2014 4:00 PM
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