Sure, we all feel like geniuses now, right? We stuck it out -- "it" being the worst economic crisis since the Great Depression -- and have now enjoyed fat and happy double-digit gains ever since the market hit bottom in March.
There's surely more to come, right? Right?!
Survey says …
Who knows? We Fools pride ourselves not on making market calls, which are a great way to get slapped silly by the market's invisible hand. Rather, we take pride in our fundamental focus. Is a company's market share likely to shrink or grow? Has its management team delivered the goods over the long haul while deftly navigating both up markets and down? And in terms of valuation, does the firm's stock look like a blue-light special or a high-end luxury item?
In my experience, that last element -- valuation -- is often the toughest taco to crack. Some companies never look cheap, after all. Others that appear to be bargains may turn out to be value traps instead. Still, in general terms, one thing remains true: When a company sports moon-shot multiples, there's little opportunity to cushion the blow when the overall market hits the skids or when the company itself blows up.
The higher they fly, the harder they fall
For example, take Research In Motion and Google. The former has gained 65% year to date, even after factoring in its recent dramatic slide. The latter has increased by some 80%. Yet sneaking a peek at this illustration of recent history should be instructive for folks who currently own either company's shares, as well as Fools who may be considering a purchase.
Could investors have foreseen the slide that chopped at least 50% off each company's value? Perhaps not, but if they'd tuned into each firm's valuation, savvy investors might have dodged a bullet by taking gains, waiting for valuation gravity to work its magic.
Shortly before its 2008 slide began, Research In Motion traded at a level that priced in more than 60 times the previous year's earnings. Google, meanwhile, sported a P/E in the 50s back when we were celebrating New Year's 2008. And while both companies have since recovered, RIMM now trades with a P/E just south of 20, while Google has clawed its way back to 38.
Bottom line: A little valuation discipline can go a long way. When an all-but-inevitable market pullback arrives, highfliers can be sitting ducks -- and future bargains, at least in relative terms.
Good company, lousy investment
Along those same lines -- and following robust run-ups of more than 40% over the last three months alone -- Citigroup (NYSE: C) and Freeport-McMoRan Copper & Gold (NYSE: FCX) could be cruising for proverbial bruisings. That goes double for Southern Copper (NYSE: PCU), whose current P/E hovers above 50 -- more than five times the company’s average over the last half-decade.
Last but not least: Caterpillar (NYSE: CAT), which is currently priced at nearly 30 times analysts’ earnings estimates for this fiscal year. Given the eternal -- and generally erroneous -- optimism of Wall Street’s Gucci-loafer set, that’s way too rich for my blood.
That’s particularly true, moreover, given the company’s deep economic sensitivity -- and the still-plentiful number of long-haul overachievers trading on the cheap: Johnson & Johnson (NYSE: JNJ), Pfizer (NYSE: PFE), and PepsiCo (NYSE: PEP), for example, currently weigh in with multiples below the broader market’s and their own five-year averages.
The Foolish bottom line
There's more to uncovering values than just parsing price multiples. Separating truly cheap stocks from merely cheap-looking ones is a full-time job.
If you'd like some assistance when it comes to avoiding value traps, be sure to check out the Fool's Inside Value service, where the emphasis is squarely on rock-solid companies trading for a song. Click here to learn more about the service while snagging -- for free -- a special report that serves up two solid investment ideas you can put to work right now. There's no obligation to subscribe, and the report is yours to keep either way. Give it a go now.
This article was first published June 2, 2009. It has been updated.
Shannon Zimmerman
runs point on the Fool's Ready-Made Millionaire and Duke Street services and doesn't own shares of any of the companies mentioned in this article. Google is a Motley Fool Rule Breakers recommendation. Johnson & Johnson and PepsiCo are Income Investor selections. Pfizer is an Inside Value pick. The Fool has a strict disclosure policy.
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