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An Argument for Buying Expensive Stocks

By John Maxfield - Mar 27, 2015 at 9:09AM

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When it comes to stocks, you get what you pay for.

When it comes to buying great stocks for a reasonable price, you shouldn't let a perfect plan get in the way of a good one.

Great stocks are rarely cheap. And when they are, they're cheap for reasons that dissuade the average investor from buying stocks at all, such as broad market crashes like we saw in 2008-2009.

Thus if you're focused solely on buying inexpensive stocks, then chances are good you'll end up owning a collection of second-rate companies, or none at all.

Superior stocks are expensive
A textbook example of this is U.S. Bancorp (USB 0.68%), the nation's largest regional bank, which has $380 billion in assets on its balance sheet.

U.S. Bancorp is exactly the type of stock -- and particularly the type of bank stock -- that all investors should want to own. Here's why:

  • It made it through the financial crisis without reporting a single quarterly loss.
  • In an industry in which efficiency is king, U.S. Bancorp is in a league of its own, with an efficiency ratio of 53.4% in 2014; its peers generally fall between 60% and 70%.
  • Its revenue streams are diverse and varied -- a critically important structure that helps to insulate the Minneapolis-based bank from the unpredictable swings of the credit cycle.
  • Its cumulative credit losses over the past decade are second to none after accounting for the composition of its loan portfolio.
  • And, last but not least, U.S. Bancorp has generated an outstanding return on investment for longtime shareholders -- nearly 25,000% over the past four decades -- handily outpacing not only the vast majority of its peers, but also the S&P 500 more broadly.

These same reasons, though, are why U.S. Bancorp's stock almost always trades for a substantial premium to the shares of other lenders. Over the past decade, for instance, the price-to-book value of its shares has consistently been nearly twice that of other regional banks.

Based on value alone, in turn, it seems safe to conclude that few value-minded investors would have participated in U.S. Bancorp's superior returns over the last few decades.

The virtue of "paying too much"
What I'm proposing is that it's better for individual investors to seemingly "pay too much" for a company like U.S. Bancorp than to either sit on the sidelines in hopes that their ideal stock will someday be sufficiently "cheap" or invest in seemingly undervalued companies that are undervalued for a reason -- most likely because they have a history of generating substandard returns.

This might seem counterintuitive to investors who follow Benjamin Graham's once-groundbreaking approach to value investing, the objective of which is to select stocks principally based upon a cheap valuation. But there are two things to keep in mind.

First, while stock valuations fluctuate, shares of great companies consistently trade for a premium relative to the shares of mediocre companies. We saw this in the case of U.S. Bancorp. The implication is that a stock with a high valuation today is likely to exchange hands at that valuation again in the future, even if it drops in the intervening time period.

To be clear, I'm referring only to tried-and-true companies that have been around for many decades. This same rule doesn't apply, for instance, to Amazon.com, which, while unquestionably amazing, is nevertheless relatively young and trades for a multiple reflecting expectations of rapid short-term growth.

Second, even Warren Buffett, the most successful and revered of Graham's understudies, has tweaked the former Columbia University professor's approach. Instead of focusing exclusively on valuation, which Buffett did early in his career, the Omaha-based billionaire now abides by the maxim that it's "far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

If you have money to invest, you shouldn't wait for the ideal moment -- namely, when patently great stocks are trading for patently low valuations like many did at the nadir of the financial crisis. Those moments come rarely, and when they do, you're likely to be too frightened to exploit the opportunity anyhow.

The better approach, in my opinion, is to buy great stocks now rather than later. You'll pay more for them, but over the long term, you'll be happy you did so.

John Maxfield has no position in any stocks mentioned. The Motley Fool recommends Amazon.com. The Motley Fool owns shares of Amazon.com. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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U.S. Bancorp Stock Quote
U.S. Bancorp
USB
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