There is carnage in the shopping aisles. Wal-Mart (NYSE:WMT), Gap (NYSE:GPS), and Aeropostale (NYSE:ARO) all have recently hit new 52-week lows. There are also a number of other retailers that aren't too far behind. At the other end of the investing world, investors are still enamored with Apple Computer (NASDAQ:AAPL) and Google (NASDAQ:GOOG), both sitting near their 52-week highs.
All five are good companies, but stock prices can and do get ahead of their underlying companies. History says buying companies at low multiples of sales, earnings, or cash flows is a strategy that rewards investors, while buying at high multiples of sales, earnings, or cash flow earns investors subpar returns at best and permanent destruction of capital at worst. Right now, for example, Wal-Mart is trading at an enterprise value-to-sales ratio of 0.7, whereas Google is trading at a ratio of 18.8.
That's not to say that Apple and Google won't grow faster than the retailers mentioned above. There's a good chance that they will. But it will be very difficult for them to grow at a rate that justifies their sky-high valuations, and neither has proven that they have moats around their businesses (i.e., competitive advantages) that can endure.
My worst investment
I learned about the risks of buying high-multiple stocks the hard way. When I started investing in the 1990s, I felt that I had constructed a well-balanced portfolio of companies and, for the most part, I had. However, as the go-go market kept going, I found myself adding companies to my portfolio at higher and higher multiples. When the bear market began in 2000, these high-fliers fell much harder than the general market, despite these companies' continued good performance. The hard drop of my high-fliers, along with the presence of a couple of stinkers in my portfolio, wreaked havoc on a portion of my savings.
The stinkers were bad enough for my portfolio, but the good companies such as Qualcomm (NASDAQ:QCOM) that I overpaid for were even worse. I initially bought Qualcomm in 1998, but my mistake was adding to my position in 1999, then adding QwestCommunications International (NYSE:Q) to the mix as well. I want to emphasize that Qualcomm, like Apple and Google, is a tremendous company, but it doesn't matter when you pay too steep a price.
As the bear market came to an end in October 2002, high-quality companies were cheap and plentiful, but I didn't have enough cash on hand to take advantage of the bargains staring me in the face. Furthermore, I was a bit gun-shy after having suffered the pain of watching my portfolio lose so much value.
A balanced approach
Two problems needed fixing. First, I needed to pay reasonable prices for good companies. Second, I needed to make sure that I would have cash on hand to take advantage of inevitable market selloffs when they occurred.
Paying a reasonable price was the most important piece of the puzzle, and while it's impossible to time the market precisely enough to get the absolute lowest trading price on a company's stock, spending time on valuation goes a long way toward preserving capital.
For the second piece of the puzzle, I began focusing on dividend-paying companies, because the additional cash flow from dividends -- particularly in a tax-deferred IRA -- provides an additional ongoing stream of funds that can be invested. In addition, good dividend-paying companies tend to increase their dividend payouts year after year, thereby providing even more of the green stuff to put to work.
The result of this balanced approach was building the majority of my portfolio around dividend-paying companies, while reserving a portion of my portfolio for high-growth small and mid-cap companies (such as Coach) that can generate income for my portfolio through capital gains rather than dividends.
Foolish final thoughts
Dividend investing has provided me with a more stable portfolio and additional cash on hand, but it's also a strategy that has been proven in academic studies to beat the market. I recommend snuggling up with a copy of Jeremy Siegel's latest book, The Future for Investors, to learn more about this greatest of investing secrets.
Further Foolishness that really pays off:
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Nathan Parmelee has no financial stake in any of the companies mentioned. Gap is a Motley Fool Stock Advisor pick. The Fool has an ironcladdisclosure policy.
