Look to Quality When Investing in a Fairly Valued Market

In the fifth year of a bull run, what's an investor to do?

Jul 11, 2014 at 8:00AM

The year 2008 and beyond has been an investing paradise for long term, buy-and-hold types -- aka Fools. But as the saying goes, what got you here won't necessarily get you there. What should investors do as the stock market continues to make new highs?

Selling out is one option, locking in gains always sounds good, but then you look at the returns of cash and bonds and it sounds less good. What about buying more stocks? Well that is tricky because investors can't find many bargains. That said, there is still one opportunity that investors have today, and it is hiding in plain sight -- upgrade the quality of your portfolio.

So many stocks have run up in price and value in the last five years, the junkier ones right alongside the high-quality companies. In fact, the latter is where the most interesting possibilities lie. 

Let's take an example of a stock on a great five-year run: Monster Beverage (NASDAQ:MNST).

MNST Chart

MNST data by YCharts

Monster's price and valuation have appreciated quite nicely over the last five years. But the past is past -- investing is a forward-looking exercise. The gains that Monster shareholders have seen are great, but taking a sober look from here means facing a P/E of 32. That number assumes a rosy future for energy drinks. 

If you compare Monster with McDonald's (NYSE:MCD) you can see that investors are paying a lot less for future growth in the golden arches than they are for Monster. 

MNST PE Ratio (TTM) Chart

MNST P/E Ratio (TTM) data by YCharts

Monster investors need to rely upon continued perfect performance. Today investors can buy McDonald's at a small discount to the overall stock market P/E of around 19. What kind of quality do investors get in return? Even though the gap in price is huge with Monster selling at nearly double McDonald's valuation, the gap in quality is not huge at all. 

In fact if you measure quality using return on equity, you can see that the two companies have quite similar quality metrics.

MNST Return on Equity (TTM) Chart

MNST Return on Equity (TTM) data by YCharts

So here is a case where you have a choice between companies with similar quality metrics and widely divergent prices and valuations. On top of that McDonald's investors get one thing that everyone, even an energy drink enthusiast, likes -- cold hard cash. McDonald's has a decades-long dividend history. Maybe Monster will pay out a dividend one day, but for now investors are stuck with a great track record, but a future that relies only on capital gain appreciation pinned to a high valuation.

MNST Dividend Chart

MNST Dividend data by YCharts

None of this is to say that Monster isn't a good company or investment. But as a thought experiment, an investor could consider selling Monster and buying McDonald's and she would get similar quality, plus a dividend, at close to half the price. There are not many true bargains out there in the market today. There are, however, relative inefficiencies and the gap between price and quality is one of them.

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Gunnar Peterson owns shares of McDonald's. The Motley Fool recommends McDonald's and Monster Beverage. The Motley Fool owns shares of Monster Beverage. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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