The holy grail of investing is finding tomorrow's top-performing stocks at a bargain price. But if you constantly focus only on investments that carry attractive valuations, you'll inevitably miss out on a big group of stocks that never seem to be cheap -- yet consistently produce returns that you simply can't afford to miss.
The cycle that never comes
Value investing has great appeal, because its premise is so simple: Pick stocks that trade at a discount to their true value, then hold them until investors recognize their real worth and bid up share prices. With many stocks, the cycle of bull and bear markets gives you ample opportunity to pick up shares when most investors are generally pessimistic and then benefit from the inevitable recoveries in sentiment that follow.
That strategy doesn't work with every stock, though. In fact, when you look at some of the stocks with incredibly strong total returns over the past 10 years, you'll find that many of them gave value investors almost no good opportunities to buy shares at anything remotely resembling an obvious bargain. Consider these stocks:
|
Stock |
10-Year Average Annual Return |
Current P/E |
Average P/E in Cheapest Year |
|---|---|---|---|
| Amazon.com (Nasdaq: AMZN) | 31.8% | 66.4 | 34.6 (2005) |
| Celgene (Nasdaq: CELG) | 25.6% | 28.3 | 34.5 (2010) |
| Intuitive Surgical (Nasdaq: ISRG) | 37.0% | 34.4 | 36.6 (2009) |
| Green Mountain Coffee Roasters (Nasdaq: GMCR) | 47.6 % | 112.7 | 22.6 (2004) |
| Cognizant Technology (Nasdaq: CTSH) | 38.5% | 32.2 | 19.6 (2009) |
| F5 Networks (Nasdaq: FFIV) | 43.8% | 50.9 | 30.3 (2008) |
| Apple (Nasdaq: AAPL) | 42.5% | 19.6 | 21.7 (2010) |
Source: Capital IQ, a division of Standard & Poor's.
You can see that in almost all of these cases, you would've been hard-pressed to justify buying these stocks on an absolute valuation basis.You could've found times when the shares traded at multiples that were somewhat lower than their typical high levels, but even during troughs, share prices often looked very pricey compared to their earnings. Only now that Apple has earned the second-biggest market cap in the entire U.S. stock market is it starting to appear like a value stock -- and that's too late for anyone looking for serious future stock appreciation.
Now, it's true that if you go far enough back, you can almost always find at least one time when a stock might have shown up on a value screen. Amazon shares proved just as susceptible to the bearish thinking of the tech bust as less viable dot-com concerns, yet it continued building on its dominant position in online retail to create the empire we're all familiar with today. Apple stalled out after the success of the Mac in the 1990s before moving to its more consumer-based bent with the iPod.
Moreover, several of these stocks have seen occasional spot declines, giving investors a quick opportunity. But to take advantage, you had to be willing to buy in during some of the most challenging times in stock market history, such as the market meltdown of two years ago.
Overall, unless you somehow get in on these stocks on the ground floor -- opportunities that are only obvious in hindsight -- then you'll reject these stocks as overvalued. That's a blind spot for value investors, but it's one you don't have to share.
Make high valuation work for you
Whenever you spot an inefficiency in the stock market -- such as investors discounting high-valuation stocks as being too risky -- you've found a potential opportunity. In this case, it's so lucrative that Fool co-founder David Gardner has singled it out as a defining characteristic of great stocks:
Every day, the Wall Street poohbahs declare this or that stock overvalued. ... If a company is increasing its earnings and, as a result, has a rising valuation, there will be someone somewhere who will argue that the company is overvalued. This is valuable because it keeps people out of a stock. Later on, as the company proves out its position as a profitable, even dominant, leader, then the skeptics finally buy -- which is what can give you serious appreciation as an early investor.
If you're used to buying only stocks with beaten-down prices, then it takes a major shift in your thinking to start paying attention to high-flying stocks that you've ignored for years. Nor are these stocks without risk; for every promising company that goes on to be the next Amazon or Apple in its field, you'll find plenty of pretenders that never live up to their full potential. But given how explosive their returns can be, finding those most-successful stocks is worth the effort.
Invest from both ends
Searching for good stocks at cheap valuations is still a noble goal. But it's not the only way to invest. If you can go beyond simply rejecting high-P/E stocks out of hand to seek companies that will dominate their peers in important ways, you'll have added a valuable weapon to your investing arsenal.
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Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance.
