Investors: Beware of These Stocks!

"Time makes fools of us all. Our only comfort is that greater shall come after us." -- E.T. Bell

Economic and financial prognosticators understand the long-term positive correlation of time and foolishness (small "f") perhaps better than anyone else. For example, in 1929, the great Yale economics professor Irving Fisher said, "Stocks have reached what looks like a permanently high plateau." For a while, at least, he appeared to be a genius, but time would eventually prove him wrong.

The 25-year test
Out of curiosity, I recently went to my local library to see what popular financial magazines were predicting back in 1983. Ten seconds later and I already had an article that proved to be downright stupid in hindsight.  

The Feb. 14, 1983, edition of Forbes warned investors about buying into "highflyer" stocks and produced a list of 35 stocks with high P/E ratios (more than 30) at a time when the overall market was trading at just 12 times earnings.

The list of 35 companies included:

Company

February 1983 P/E

Return, 1983-Present

Home Depot (NYSE:HD)

70

7,913%

Lowe's (NYSE:LOW)

31

4,188%

Pulte Homes (NYSE:PHM)

38

431%

Wal-Mart (NYSE:WMT)

31

7,654%

*P/E data source: Forbes magazine, Feb. 14, 1983.

In fairness to Forbes, I hadn't even heard of many of the stocks on the list, so I assume they were either acquired or faded into obscurity. So, all in all, the author was right to doubt at least a few of the 35 "highflyers."

But that's not the point
Here's the thing: Even assuming that the other 31 stocks on the list went completely bankrupt, $1,000 invested in each of the 35 stocks back in 1983 would still be worth $205,857 today -- a 488% gain. In other words, those four big winners more than made up for 31 losers (though it should be noted that you would have trailed the market by investing in 31 stocks that went to zero).

Going 4-for-35, however, is atrocious. You can do better -- and substantially beat the market -- by finding and doubling down on the companies that have the management teams and market opportunities (such as Wal-Mart and Home Depot) to grow into their valuations. These types of seemingly high-P/E stocks present great value opportunities in the long run.

For example, Research In Motion (Nasdaq: RIMM  ) , eBay (Nasdaq: EBAY  ) , and Amazon.com (Nasdaq: AMZN  ) have always traded with high multiples, but have earned their expensive price tags by dominating their niches and rewarding long-term investors with outsized earnings growth.

Today's highfliers
There are plenty of stocks in today's market with higher-than-average multiples, and while they may look "expensive" today, we've seen that some may actually turn out to be some of your cheapest buys in the long run.

To identify potential long-term winners, investors should look for companies with innovative products or services, preferably led by an engaged founder, and the potential for dominating its market niche.

If you want some guidance for finding a few promising highfliers, Motley Fool co-founder David Gardner and the Motley Fool Rule Breakers team can help. To date, their biggest winner has been Intuitive Surgical, which is up nearly 600% since it was first recommended in our April 2005 issue. On average, their picks are beating the market by 15 percentage points.

If you'd like to see the other stocks they've recommended, a 30-day trial to Rule Breakers is free of charge. Just click here to get started. There is no obligation to subscribe.

Fool contributor Todd Wenning hopes posterity judges him well. He does not own shares of any company mentioned. Amazon.com and eBay are Motley Fool Stock Advisor picks. Home Depot and Wal-Mart are Inside Value recommendations. The Fool's disclosure policy wishes life was more like 1983.


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