Value Investors Beware: Buying Cheap Can Cost You Dearly

Looking at the history of the S&P 500 index, you'll see a pretty clear trend that emerges among the best performing periods.

Source: irrationalexuberance.com.

With the exception of 1994, the P/E ratio at the beginning of all of these periods was well below the market's long-term average valuation of 15.5. So the strategy seems simple: Invest when market multiples are tantalizingly low.

Not so fast, smart guy
Sure, this strategy might work for the overall market, but what if you're trying to beat the market by investing in individual stocks? If we look at some of the best performing U.S. stocks over the past five years, we may be left scratching our heads.

Source: Capital IQ, a Standard & Poor's company.

While these valuations aren't all as astonishingly high as Intuitive Surgical, none would have been considered "cheap" on the basis of their P/E at the time. But it gets even more interesting when we look at some of the worst performing stocks over the same period.

Source: Capital IQ, a Standard & Poor's company.

There's more to "cheap" than price
Leave it to good ole Warren Buffett to speak the truth: "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

As the stocks above suggest, getting a rock-bottom price for a stock is hardly a guarantee that you're going to bag outstanding gains. Or even avoid getting wiped out.

Five years ago, Avis' valuation may have looked attractive to some investors, but the company was slugging it out in the mature rental car industry and had operating income that didn't even cover the interest expense on its debt. Intuitive Surgical, meanwhile, had a scary-looking P/E, but sported a nearly debt-free balance sheet and was growing like a weed thanks to its revolutionary surgical systems.

But there's more ...
Going back for a second helping of Buffett wisdom, The Oracle has said on repeated occasions that with a smaller sum of money, he could produce annual returns of 50%. How? Well, part of the reason is that investing in smaller companies suddenly becomes feasible for him.

And this makes perfect sense. Of the top performers listed above, Intuitive Surgical was the largest among them in 2004, and its market cap was only $1.2 billion. Arena Resources and Green Mountain clocked in at a mere $68 million and $171 million, respectively. The small size of these companies gives them a huge advantage over the GE's (NYSE:GE) and Coca-Cola's (NYSE:KO) of the world because growing $7.8 million in profit (Green Mountain's fiscal 2004 net income) is much easier than growing $17.2 billion (GE's 2004 net income) or $4.8 billion (Coke's).

It would certainly be a bad idea to ignore valuation altogether -- after all, Buffett did say you should get a "fair" price -- but it seems that too much of a focus on finding the lowest priced stocks can actually hurt your returns. Instead, you're probably much better off focusing on the two factors I've outlined above:

1. Quality: Make sure you're buying a company with a good business, a solid balance sheet, and a bright future.
2. Small size: Smaller companies have a much easier time delivering knock-your-socks-off growth than their larger counterparts.

With a mandate to find the very best small cap stocks out there, the investing team at the Motley Fool Hidden Gems newsletter eats, sleeps, and breathes these concepts. If you'd like to check out what the team has added to the Hidden Gems real-money portfolio, you can take a free 30-day trial.

Green Mountain Coffee Roasters, Hansen Natural, and Intuitive Surgical are Motley Fool Rule Breakers recommendations. priceline.com is a Motley Fool Stock Advisor recommendation. Coca-Cola is a Motley Fool Inside Value pick. Coca-Cola is a Motley Fool Income Investor selection. Try any of our Foolish newsletters today, free for 30 days.

Fool contributor Matt Koppenheffer owns shares of Coca-Cola, but does not own shares of any of the other companies mentioned. The Fool's disclosure policy has never once been caught with its pants down. Of course, it doesn't actually wear pants ...