FOOL ON THE HILL: An Investment Opinion
It's not a hard-and-fast rule that a great company will always make a great stock. While the past has shown that it can be quite hard to overpay for superior quality companies, expecting every stock with a high P/E ratio to beat the market if simply held long enough is unreasonable. "Holding for the long haul" won't save you if from the outset you pay too far beyond a firm's intrinsic value.
The main way that a great company can turn into a bad stock isn't really related to the company at all. It has nothing to do with bad management, a dumb acquisition, or an unforeseen loss of competitive advantage. Rather, great company/bad stock situations are most often created by investors who offer to fork over too much for a cut of a firm's future cash flows. This may sound plainly obvious if you pay too much for what at first appears to be a great company but turns out to be a piece of crap, but it can also happen if you pay too much for a company that is in reality a truly great value creator.
Keep in mind, history has shown that it can be very hard to overpay for the world's greatest companies. For instance, as has been pointed out in this column on an earlier occasion, an investor could have paid as much as 90 times earnings for shares of Coca-Cola (NYSE: KO) in 1972 and still topped the return of the S&P 500 over the ensuing 25 years. Likewise, a purchase of Philip Morris (NYSE: MO) at up to 75 times earnings would have yielded a similar result over the same span. Kind of blows a big hole in the arguments of some of the value zealots out there who are only willing to buy a company if its P/E ratio is in the single digits, doesn't it?
While just a pair of frozen-in-time examples, such is the power of the long-term buy-and-hold stock investing strategy when employed with an exceptional business whose intrinsic value is seriously mis-stated by the market. However, this doesn't mean that a superb company will always make a superb stock at any price or that intrinsic value is never overstated.
After all, Coke at 95 times earnings in 1972 and Philip Morris at 80 times would have resulted in underperformance between 1972 and 1997. (For the record, Coke was actually priced at 46 times earnings in 1972 and Philip Morris fetched a multiple of 24 times, according to Jeremy Siegel's Stocks for the Long Run. In 1972 as in 1997, both companies were considered "pricey" relative to the multiple of the S&P 500.) While theoretical examples only, the point is that there is a very real penalty to yielding to the overvaluation siren and paying a price above intrinsic value for a stock, even if it represents a stake in a remarkable business.
Many of the folks who are concerned about the rich valuations in some areas of the stock market today would no doubt argue that the legitimate concept of paying up for perceived high-quality businesses is being stretched pretty thin. I tend to agree with them.
Despite the negative return of the S&P 500 index this year and recent warnings from highly valued member firms such as Dell (Nasdaq: DELL), Intel (Nasdaq: INTC), and Apple (Nasdaq: AAPL), by my count there are still 14 companies on the index with forward P/E's north of 100. Indeed, many of these companies deserve a higher-than-average earnings multiple. All else equal, a company that can be expected to generate economic returns well above its cost of capital for an extended period of time is worth more than a firm with more average characteristics. But in the end, will history show that all 14 of these companies were worth their current multiples? That's a tough bet to make.
If you are buying some of the triple-digit multiple stocks out there today with the mind that they will make winning long-term investments, you are placing an inordinate amount of weight on the perception that your company is in fact a quality business of the highest order. In this kind of game, the odds that you have unearthed the Hope Diamond of business quality are firmly against you. Investing with an eye toward predicting the most improbable result as opposed to the most probable one is a dicey way to approach the market, to say the least.
Furthermore, justifying a purchase of a triple-digit multiple stock with the default excuse "But I'm in this for the long-haul" won't make a lick of difference in the end if you, in fact, paid too much for a stock from the get-go. Don't expect a plethora of patience to bail out a modicum of analysis. Waiting a hundred years for your purchase price to be returned to you in the form of a firm's earnings is pushing the idea of delayed gratification to the limits, in my opinion. Sure, in terms of its business fundamentals such a company may in fact be a gorilla, but in time its stock will turn out to be an ant if you overpay.
And even if over the next 25 years your favorite, triple-multiple company turns out to be as economically powerful as Standard Oil, Coca-Cola, and Microsoft (Nasdaq: MSFT) all rolled into one, there is still such a thing as an unreasonable price. If you pay too far above a company's intrinsic value, be prepared to suffer the consequences. Either you will incur a permanent loss of capital or you will spend a very long time on the couch waiting for the business' long-run economic reality to catch up with the market's short-term misfit pricing. That's something to keep in mind as you look for long-term, large cap "bargains" resulting from the market's recent gyrations.
Addendum: S&P 500 members with forward P/E ratios over 100 (as of Oct. 6)
TWX * 208
* in the midst of being acquired