The premise makes more than enough sense: For the same reason consumers want more bang for their buck at the stores they regularly shop, investors want to buy attractively valued stocks. The metric by which a stock's price is justified is the amount of income allocated to each share. The more earnings one can buy into per investment dollar, the better the bargain.
Except, this theory doesn't hold up terribly well when put into practice in the real world. Many stocks that are seemingly priced at a premium end up yielding more shareholder gains than a so-called "cheap" stock does.
Unintuitive results
It's a divisive debate among investors: Should one pay relatively high prices for names like Amazon.com (AMZN 0.41%) and Apple, which have handily outpaced the broad market on a percentage basis in recent years despite their lofty valuations? Or will the market environment eventually return to its pre-2008 condition, when value stocks regularly outperformed growth stocks? For that matter, are value stocks by definition also cheap stocks?
Investors too often confuse a stock's valuation with its plausible potential for gains. Image source: Getty Images.
There's a nuance often lost in the search for these answers, as well as the subsequent search for the market's best opportunities. That is, the relative (to earnings) price of a stock may be the least important performance factor of all.
One doesn't have to look too far to find examples of value-minded strategies that didn't pan out. Take Ford (F 0.81%) as an example. While its glory days are likely to be in the rearview mirror, the carmaker actually came out of 2008's recession with respectable traction. The top line grew well (even if not steadily) from 2010 through 2018, and while they didn't grow quite as well, operating profits were actually better through 2016's peak in auto sales than they were headed into 2008's subprime mortgage meltdown. Ford shares were dirt cheap for that entire eight-year span too, rarely exceeding the teens and usually found in single-digit territory. The stock ended that time frame right about where it started it, however.
Being undervalued by almost all measures didn't translate into stock performance.
There are surprising results at the other end of the spectrum as well -- stocks that performed amazingly well despite sporting uncomfortably high P/E ratios while they soared. The aforementioned Amazon is one of them. Not once in the past 10 years has its trailing-12-month P/E ratio fallen below 70; more often not it's been above 100. It's an outlandish valuation most investors wouldn't even consider paying for nearly any other name. Yet, the pricey pick has paid off. Amazon shares are up nearly 3,000% over the course of the past decade.
And it's not as if Amazon is an odd exception to the rule.
The new normal isn't exactly new
What gives? In the simplest terms, there's more -- a lot more -- to the way investors collectively reward a company's performance through that company's stock price. Perhaps now more than ever, stories count, as does the trajectory of an organization's fiscal results. Prices relative to earnings aren't a game-changer anymore.
It's a dynamic that pushes the boundaries of what counts as a sound stock-picking regimen. Morningstar senior analyst Tony Thomas put it like this in the latter part of last year:
It seems that, much like the end of the 1990s, investors are excited by what's new and disruptive rather than tried-and-true. Value just hasn't had an attractive story to tell -- it's almost like it's too boring. I've heard managers complain that Tesla (TSLA 5.46%) has had a higher market value than more-established car companies. ... Today's cynic might ask, 'Who wants to invest in a company that owns forest lands when one could be a part of the Next Big Thing?'
As in Tesla's case, excitement rather than results has undoubtedly driven the bulk of the market-beating performance that Amazon has dished out for the past several years. It did pay off for investors willing to take their shot though.
Thing is, value stocks' lack of stories and the potential of being out in front of a growth trend isn't actually a new idea. Neither is the dismissal of valuation as an important factor when it comes to picking stocks.
When William J. O'Neil (the founder of Investor's Business Daily) published the very first version of How to Make Money in Stocks back in 1988, it was the first book to reverse-engineer the qualities of the market's best-performing stock picks. It did this by looking back at 38 years' worth of data. It was this same data-driven scientific study that led to the CANSLIM approach to finding the market's top prospects; each letter of the acronym explains one of the top seven criteria investors should consider before making a trade. Curiously, not one of those seven criteria O'Neil found to be vitally important is valuation-related. One of them, on the other hand, does encourage investors to search for companies that make products decidedly in demand at any given time.
Your takeaway
None of this is to suggest a stock's price compared to its earnings -- past or projected -- should be entirely ignored when making an investment decision. Everything matters, at least to some degree.
For too many investors though, a stock's valuation may be too much of factor, or perhaps the only factor. There's more to stock analysis than just a stock's price relative to a company's results. Investors should be making qualitative judgments about individual companies as well.
