Investment Philosophy, Rule Four: A Fair Price

Motley Fool analyst Jason Moser chats with Rick Engdahl in a side-of-desk interview about developing a personal investment philosophy, and shares his own four-point system for deciding whether a particular stock is right for his portfolio.

In this video segment, Jason discusses P/E ratios, why they're not always a great indicator, and what to do if a company meets all your other criteria but just feels a little too pricey.

A full transcript follows the video.

Rick Engdahl: I noticed your fourth and final point here, you talk about fair price. You didn't say a "cheap price." What is a "fair price"?

Jason Moser: Fair price is a bit subjective.

Rick: Someone who's admittedly not a value investor.

Jason: It's a bit subjective, yeah. I think that's something where valuation is not a perfect science. It's certainly something that you can look at from a number of different ways.

We see the all-reliable price-to-earnings ratio is becoming less and less relevant, I think, because business has changed. I think the P/E ratio was very helpful for looking at companies that are maybe a little bit mature in their age, that are a little bit more reliable, a little bit more consistent, and a little bit more predictable.

But I think that when you're looking for companies that are beginning a long-term trend -- growth companies, so to speak -- the P/E ratio becomes less and less applicable because the companies are focused so much on reinvesting in the business in order to fund their growth.

Amazon.com (AMZN -1.64%) is one of the most polarizing investments in the world, I think, because, on the one hand, people can't believe that this company that just made $16 billion last quarter took a net loss of $0.02 per share.

But, by the same token, if you look at it from their cash flow perspective, you can see that they're generating a lot of money and that they're reinvesting all of that money back into the business to grow this formidable scale.

All of a sudden, Amazon's got this footprint that just covers the entire world, and they seemingly do everything, and they're able to fund that growth on their own, right?

The P/E ratio is pretty much useless there. Then looking at a fair price... Well, that's kind of difficult to say. I remember buying some shares of Amazon at $180 and thinking, "Eh, it seems like it's a relatively fair price," and it cracked $300 just the other day, so I'm feeling pretty good about that so far.

But, by the same token, if you look at something like a Chipotle -- which had crept all the way up to around 55 times earnings based on that price-to-earnings ratio -- when you look at that compared to some of the other players in the space, like your Starbucks and your Panera, Chipotle all of a sudden comparatively looked pretty expensive.

Even when you compared... a Chipotle to a Panera was a very fair comparison because of the size of the companies. The store bases were about the same, so you could see. Maybe there was something... what were we missing? What was the market missing? Why was that stock price so high?

Who knows? That's just the market behavior, right? A stock gets in the market's good graces and it gets bid up beyond what seems to be rational, and then that's where you have to be able to say, "All right, that's a little bit beyond what I feel comfortable paying, and this is why."

What I can do is I can keep that stock on my watchlist, I can wait for it. At some point, there will be an earnings miss or something that will happen that will bring that stock price down a little bit.

Another way to get around that is if you have a company that you really enjoy and you want to be a part of, if you feel like the price is a little bit too expensive but you really want to be a part of it anyway, you can buy a small position to get started.

That way you get skin in the game. You're part of the story, and then you can continue to add shares opportunistically as the market allows.

I think that's the one thing that... Short-term investors don't really think about this, but they can look at this just really as sort of an ongoing story, that if you have a company that you really like, it's not just buy your shares and be done. You can buy your shares in stages.

We talk about buying them in thirds here, where you buy a small position to get started, you learn more about the company and then you buy some more shares to add to that position, and then you buy some more shares as the opportunity arises.

You could go even further with thirds; you could go fourths, fifths, or sixths. The point is that every earnings season, these companies announce their earnings.

These earnings things are all just expectations games, and they serve as short-term catalysts, I think -- they could go back to that catalyst point -- in that if a company misses expectations or offers some kind of guidance that is less than what Wall Street's expecting, the stock price tanks, but was there anything really substantial behind that tanking, other than an expectations game?

I think a lot of the time the companies that we follow, that have these great management teams and these competitive advantages... you can find some really interesting buying opportunities then. I think that really price... it's a tricky one. A valuation, there are a million different ways to look at it.

Yeah, value investors are typically very... they maintain that thought process or that philosophy that they need that margin of safety -- which is great, because you have that margin of safety and you protect yourself against the inevitable blunder -- but it also maybe would limit you to not considering certain companies to invest in.

That's why I never really wanted to put myself in one camp or another. I've always just wanted to be an investor who's looking to make money and be a part of some stories that I care about.