The S&P 500 hit a new all-time high last Friday, surpassing its previous record from February. The index is now up 5% year to date -- a truly remarkable recovery given that the index was down over 17% year to date at its intraday low on April 7.
Here's why investors should continue buying stocks even though the major indexes are hitting new highs, but why investing in quality companies is especially important when valuations are elevated.
Image source: Getty Images.
Get comfortable buying high
Buying a higher price goes against every instinct ingrained in us as consumers. Buyers benefit when clothing goes on sale, cars can be purchased below sticker price, or when housing prices or land values fall.
Most goods are stagnant assets. There's very little chance that a pair of jeans you buy today will be worth more a few years from now. And cars fall in value the second they are driven off the lot.
House prices and land values in growing urban areas have historically increased over time, but it's not because the land is magically better than it used to be. Rather, it's all about supply and demand.
Stocks are different. They represent partial ownership of a company. No matter how small, a slice of a big pie can be powerful if the company compounds in value. And yet, investors still often make the mistake of assuming a stock is a good buy because the price is lower, or that a stock is not a good buy or is worth selling because the price has gone up.
A good stock to buy near an all-time high
Visa (V 0.96%) is a good example of a well-known company that has continued to go up in value for all the right reasons. Its business model has remained essentially the same for decades. However, what has changed is a massive shift away from cash payments toward debit and credit cards and digital payments.
The company makes money when its cards are tapped, swiped, or entered digitally. It earns revenue based on the volume and frequency of transactions with its cards. And yet it doesn't bear the credit risk of its customers. Instead, it partners with financial institutions to bear that risk.
The larger and more secure Visa's network becomes, the more merchants may be willing to absorb Visa's fees so they don't hurt their sales. At the same time, consumers are incentivized to use their cards for as many purchases as possible, given the purchase protection offered by many financial institutions and credit card rewards programs.
It's a simple and relatively easy-to-understand business model that has made patient investors rich.
As you can see in the above chart, Visa has extremely high margins because it converts over half of its revenue into pure profit -- which has helped the stock price increase over 400% in the last decade. And because Visa's expenses are manageable, it can afford to pass along profits to shareholders by repurchasing stock and paying a growing dividend.
Just because Visa's stock price has compounded several-fold over the long term doesn't mean the stock is a bad buy now. Visa commands a premium valuation with a price-to-earnings (P/E) ratio of 35 compared to its 10-year median P/E of 33.2. But its forward P/E is 30.7, suggesting analysts believe that Visa has the qualities necessary to grow into that valuation over time.
NYSE: V
Key Data Points
Be selective
Visa is just one of many companies hovering within striking distance of all-time highs that could still be worth buying now. The stock isn't as good a deal as it was a couple of months ago, but it could still be a solid long-term investment.
When the broader market is undergoing a rapid sell-off, many phenomenal companies can fall to bargain-bin valuations. But when the major indexes are making new highs, it is even more important for investors to be selective and only put their hard-earned savings into companies they are highly committed to.
In sum, folks shouldn't stop investing just because stocks have gone up, but rather, understand the effect of valuation changes on their existing holdings and how price increases could impact the risk and potential reward of stocks on their watch lists.
