Saturday, December 6, 2014

Paying Up For Quality Stocks

Price is what you pay, value is what you get. - Warren Buffett
A few years back, my wife and I were shopping around for a leather couch to put in our new home. As we walked around the showroom of a furniture store and had a look at some of the price tags for the couches, however, I realized our bank account would end up being a little lighter than I expected. Real leather couches don't come cheap.

Never eager to spend large amounts of money, my attention quickly turned to the faux leather options. Much to my delight, these were much cheaper. For a fraction of the price of a real leather couch, we could get the same size and design.

And besides, I reasoned, visitors wouldn't be able to tell the difference anyway. Why spend the extra money?

It seemed like a sweet deal at the time, but things have changed.

Today, my "deep value" couch is falling apart -- literally -- and I find myself back in the market for a new couch. Had I originally paid up for a high-quality leather couch, I probably wouldn't be in my current predicament. The poor man pays twice, indeed.

My mistake was this -- I only considered the price of the faux leather couch relative to the real leather couch without considering the prices relative to their respective quality.

As investors looking to buy stocks on the cheap, we often fall into the same trap -- we erroneously think a company with a lower multiple presents a better deal than one with a high multiple. While that may hold true when we're comparing two identical assets, the rule breaks down when we're comparing assets of different quality.

While the market isn't perfectly efficient, it is generally efficient, so more times than not tomorrow's great companies won't be found using a low price/earnings screen. If you want a chance to own a few of tomorrow's great companies, then, you'll need to eliminate your aversion to paying premium multiples.

As you might deduce from my story about couch shopping, this is something I've struggled with in my own portfolio. On a number of occasions, I've had a case of sticker shock and balked at investing in promising companies only to watch those stocks push higher as their competitive advantages, pricing power, and earnings growth more than justified their premium prices.

The risk with buying premium-multiple stocks is that today's premium-multiple will be tomorrow's average-multiple and your returns will be decimated by a re-rating. Reversion to the mean is a powerful force, of course.

As with any investment, it's critical to get a feel for the market's current expectations for the company and weigh them against your own. Equally important is the ability to tell the difference between a great company from an average company. If you're confident in your evaluation of both factors, you shouldn't shrink from paying up for quality stocks.

Related posts: 
What I've been reading/watching this week:
Stay patient, stay focused.