LONDON -- At the core of many investors' buying decisions is the concept of "margin of safety." This is a central tenet of financial guru Ben Graham's investment philosophy, and it has stood me in very good stead over the years.
In basic terms, to buy into a company I have to be sure that the valuation is cheap and so the share is much more likely to rise than fall. That's why I tend to steer clear of companies with sky-high valuations, as any sign of slowing growth can send the share price tumbling.
After all, time and again, we have seen growth shares, from SuperGroup to Global Brands rocket and then fall to earth, leaving investors burnt.
Overpriced, or not?
But, in some cases, the concept of "margin of safety" just doesn't apply. Take the case of chip designer ARM (ARM) (ARMH). I took a look at this company about a year ago. At the time it was priced around 600 pence, on a forward price-to-earnings multiple of 45.
No doubt this was an impressive and growing company, but surely this was just too expensive? Surely the share was over-valued, and was likely to crash? That was my view at the time, and I think many readers agreed with me.
As it turned out, instead of crashing, the company's shares have rocketed. ARM has had an astonishing rise in value, and the share price now stands at 870 pence: that's a return of 45% in one year. The company is now on a forward P/E ratio of 60!
Then there is Amazon (AMZN -1.65%). This share has gone from $180 to $267 in 2012: a rise of 54%. The company is now on a forward P/E ratio of 150.
How on earth do you explain this? According to our traditional valuation metrics, these companies were expensive at the beginning of 2012, but a year later they are even more expensive.
Why is growth so expensive?
Well, it seems to me that investors are looking into the future, and they are putting a price on that future. And I see their point. After all, isn't ARM the future of microprocessors? The reduced instruction set architecture of ARM chips mean that they are energy-efficient, produce less heat and are still fast -- ideal for the smartphones and tablets that represent the future of computing.
That is why ARM's sales and profits are rocketing. In comparison, its rival Intel (INTC 1.77%) is suffering from steadily falling sales as more and more customers buy tablets rather than WinTel-based computers. Its latest results show sales fell by a quarter. While ARM's share price has been rising, Intel's has been falling. Its fast but bulky and energy-hungry chips are now the dinosaurs of the microprocessor world. Intel was cheap, but it has been getting cheaper.
What about Amazon? Well, surely this company is the future of retail? It started out selling books, then music, then electronic goods. Now it sells just about everything you would want to buy, at the cheapest price, and delivers it quickly. It is even selling groceries and clothing. It has the lowest-cost and most efficient business model in retail.
The advance of Amazon has largely led to the demise of high-street names such as HMV and Comet. It dominates the world of Internet retail. It looks like it'll soon dominating the world of retail, full stop. More than any other company, Amazon represents the future of retail.
Ride that wave
Both these companies are riding the wave of long-term trends which are only just getting under way.
Both ARM and Amazon are companies that will keep on growing for many years into the future, establishing dominant positions, with large moats and enormous pricing power. When they reach this stage, their profits will rocket and their sky-high valuations will no longer be so, well, sky-high. These companies represent the future, and buying a stake in the future can be expensive.
One investor who is a past master at spotting trends early is Warren Buffett. He invested in consumer goods company Coca-Cola at the beginning of the West's consumer boom. His view of trends in retail has led him to buy into one particular British company, so why not read this free article on "The One U.K. Share That Warren Buffett Loves."
