Sure, we all feel like geniuses now, right? We stuck it out -- "it" being the worst economic crisis since the Great Depression -- and have now enjoyed fat and happy double-digit gains over the past three months.
There's surely more to come, right? Right?!
Who knows? We Fools pride ourselves not on making market calls, which is a great way to get slapped silly by the market's invisible hand, but rather on our fundamental focus. Is a company's market share likely to shrink or grow? Has its management team delivered the goods over the long haul while deftly navigating up markets and down? And in terms of valuation, does the firm's stock look like a blue-light special or a high-end luxury item?
In my experience, it's that last element -- valuation -- that's often the toughest taco to crack. Some companies never look cheap, after all, while others that appear to be bargains may turn out to be value traps instead. Still, in general terms, one thing remains true: When a company sports moon-shot multiples, there's little opportunity to cushion the blow when the overall market hits the skids or when the company itself blows up.
The higher they fly, the harder they fall
Take, for example, Research In Motion and Google. The former has gained more than 70% year to date, while the latter has increased by roughly 30% over the period. Yet sneaking a peek at this illustration of recent history should be instructive for folks who may currently own either company's shares, as well as Fools who may be considering a purchase.
Yikes, that's a long way down. But, to be fair, that kind of rearview analysis always begs the question of whether investors could have -- or should have -- seen the writing on the wall. My take: Perhaps not, but if they'd tuned into each firm's valuation, savvy investors might have gotten an early warning.
Shortly before its slide began, after all, Research In Motion traded at a level that priced in more than 60 times the previous year's earnings. Google, meanwhile, sported a P/E in the 50s back when we were celebrating New Year's 2008.
Bottom line: Be afraid of these kinds of stocks. Be very afraid. When an all-but-inevitable market pullback arrives, they are sitting -- or in this case flying -- ducks.
Good company, lousy investment
Make no mistake. Like Google and RIMM, these are fine businesses; their stocks are just not finely priced. Indeed, with their swollen multiples, the downside risk of dreaded "multiple compression" is just too great, particularly when long-haul overachievers like Microsoft
And if those discounted cash-cow gushers aren't the 'droids you're looking for -- and if you're really focused on high-flying heavyweights with ample room to run -- consider Berkshire Hathaway
The Foolish bottom line
To be sure, there's more to uncovering values than just parsing price multiples. Indeed, separating the wheat from the proverbial chaff -- i.e. stocks that merely look cheap -- is a full-time job.
If you'd like some assistance when it comes to avoiding value traps, be sure to check out the Fool's Inside Value service, where the emphasis is squarely on rock-solid companies trading for a song. Click here and you'll have 30 no-risk days to decide if Inside Value is for you. There's no obligation to subscribe and your guest pass is absolutely free. Give it a go now.
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This article was first published June 2, 2009. It has been updated.
Shannon Zimmerman runs point on the Fool's Ready-Made Millionaire and Duke Street services and doesn't own shares of any of the companies mentioned in this article. Google is a Motley Fool Rule Breakers recommendation. Wal-Mart, Berkshire, and Microsoft are Inside Value selections. Berkshire and Amazon are Stock Advisor picks. The Fool owns shares of Berkshire Hathaway and has a strict disclosure policy.