"People who chase growth, who chase highfliers, inevitably lose because they paid a premium price." — Seth Klarman
You may recall the old joke: Do you want to know how to become a millionaire in the market? Start out with $2 million. The old adage is particularly salient for investors who tend to buy and hold stocks with high price to earnings (P/E) ratios.
Few things in this world are as ephemeral as the price of a high P/E stock. When the market invariably loses their infatuation for such companies, their lofty valuations quickly decline. Although, the valuations of these companies can occasionally remain in the stratosphere for years at a time. The fact that the valuations of certain companies can hold their sky-high multiples for an extended period gives the investor the illusion of safety; nothing could be further from the truth.
The practice is consummate to performing a high-wire act without a safety net. The fact that the performer has navigated the wire successfully a thousand times does not remove the element of risk from his performance. Instead, the performer's history of success only serves to obscure the risk. Variables such the increasing age of the performer or sudden gusts of winds are not generally considered. Neither are his past slips which did not prove fatal. Simply stated, the fact that the performer has been successful in every prior attempt does not remove the risk for all of his subsequent performances.
The problem with investing in high P/E, glamor stocks lies in the nature of their potentially rapid demise. Investing in such companies is analogous to a lumberjack hacking away with seemingly no effect. When the lumberjack finally hits the crowning blow and yells "timber" little time is left for anyone to escape from harm's way.
An earnings or revenue miss, a downgrade from a respected analyst, or a perceived negative change in the efficacy of the company's business model by the market can bring about almost an instant decline in the value of a high-flier. Unfortunately, investors in such companies generally have little chance of escaping unscathed after the unanticipated event occurs.
The Decline in the Price of RIMM Stock
Research In Motion (RIMM, Financial) was formerly one of Wall Street's glamor stocks. RIMM stock increased from a low of around a dollar and a half a share during the late summer pull back of 2002, to a high of around $140 a share in early 2008. During that period the company's extraordinary growth was fueled by the increasing popularity of its Blackberry smart phones. The high P/E multiple of the stock reflected the high growth of the company's revenues and earnings per share. The following table summarizes the year-end price-per-share multiples for RIMM in the trailing 10 years:
Industry: Diversified Communication Services
In fiscal year 2005 ending in February of 2004, RIMM recorded EBIT (earnings before interest and taxes) of $66.17 million. By fiscal 2011, the company had recorded EBIT of $4.64 billion. Today, the price per share of RIMM is roughly equivalent to its price per share in early 2004 although the company has increased its EBIT by a multiple of approximately 70-fold.
Such is the precarious nature of investing in high P/E stocks. The high-P/E investor is totally reliant upon the mercy of the market to maintain the peak multiple of the stock. Any negative news, a decrease in growth or even a perception that the company's products might becoming obsolete can cause the stock to plummet.
What Determines the Price Movement of a Stock?
The price of an equity moves higher in one of two ways: either the stock maintains its multiple and moves higher by increasing its earnings or the market for whatever reason, decides to assign the stock a higher multiple. Conversely, a stock moves lower when either its earnings are in decline or the market begins to assign it a lower multiple for whatever reason. The latter has been the case with RIMM as the market has been anticipating that the company’s profits and margins will begin to erode.
As Seth Klarman suggests the problem associated with buying stocks with high multiples is reflected in the fact the investor is paying a premium price. The practice contains no margin of safety. On the other hand, if the investor chooses a low multiple stock and exercises patience, the investor will likely be rewarded eventually so long as the company continues to maintain its earnings.
Typically, the market will eventually raise the multiple it is willing to pay for a stock when it becomes apparent that the companies' profits are sustainable. Secondly, if the company sustains its earnings, the shareholders will likely be rewarded in the form of dividends or buy-backs which will either return money to shareholders or provide them with a larger share of the company.
The key is determining if the earnings of the company are sustainable. In strict Grahamite terms, the value of the company will eventually be determined by its future cash flows. If the profits of the company erode, then the lower multiple is justified. If the profits are sustainable then the low multiple represents a bargain and accords the investor a substantial margin of safety.
Epilogue
RIMM stock may or may not represent value at its current valuation. If the company is able to maintain its future cash flows near its current levels, then long term investors will likely be rewarded. However, if the earnings of RIMM begin to erode in the future then the stock is probably a value trap.
Such conjecture is not the subject of today's discussion; rather the subject involves the perilous nature of investing in stocks with excessively high-P/E ratios. The number one concern for every conservative value investor should be purchasing stocks which are on sale. Stocks which are severely discounted rarely move in short order. Value investors should never expect to earn their gains quickly. If that becomes their aim then they have probably entered into the land of speculation rather than investment.
Readers who have followed my column are well aware of my reverent attitude towards patience. If I was forced to specify one essential personal attribute which trumps all other in regard to successful investing, it would be patience. Show me an individual with average intelligence and extreme patience and I will show you a successful investor. On the other hand, show me an individual with a 150 IQ and virtually no patience and you will likely be witnessing an unsuccessful speculator.
Patient investors have no reason to purchase stocks with bloated P/E multiples and that in itself is the primary reason they beat the market, at least in the longer term.
You may recall the old joke: Do you want to know how to become a millionaire in the market? Start out with $2 million. The old adage is particularly salient for investors who tend to buy and hold stocks with high price to earnings (P/E) ratios.
Few things in this world are as ephemeral as the price of a high P/E stock. When the market invariably loses their infatuation for such companies, their lofty valuations quickly decline. Although, the valuations of these companies can occasionally remain in the stratosphere for years at a time. The fact that the valuations of certain companies can hold their sky-high multiples for an extended period gives the investor the illusion of safety; nothing could be further from the truth.
The practice is consummate to performing a high-wire act without a safety net. The fact that the performer has navigated the wire successfully a thousand times does not remove the element of risk from his performance. Instead, the performer's history of success only serves to obscure the risk. Variables such the increasing age of the performer or sudden gusts of winds are not generally considered. Neither are his past slips which did not prove fatal. Simply stated, the fact that the performer has been successful in every prior attempt does not remove the risk for all of his subsequent performances.
The problem with investing in high P/E, glamor stocks lies in the nature of their potentially rapid demise. Investing in such companies is analogous to a lumberjack hacking away with seemingly no effect. When the lumberjack finally hits the crowning blow and yells "timber" little time is left for anyone to escape from harm's way.
An earnings or revenue miss, a downgrade from a respected analyst, or a perceived negative change in the efficacy of the company's business model by the market can bring about almost an instant decline in the value of a high-flier. Unfortunately, investors in such companies generally have little chance of escaping unscathed after the unanticipated event occurs.
The Decline in the Price of RIMM Stock
Research In Motion (RIMM, Financial) was formerly one of Wall Street's glamor stocks. RIMM stock increased from a low of around a dollar and a half a share during the late summer pull back of 2002, to a high of around $140 a share in early 2008. During that period the company's extraordinary growth was fueled by the increasing popularity of its Blackberry smart phones. The high P/E multiple of the stock reflected the high growth of the company's revenues and earnings per share. The following table summarizes the year-end price-per-share multiples for RIMM in the trailing 10 years:
Industry: Diversified Communication Services
Avg P/E | Price/ Sales | Price/ Book | Net Profit Margin (%) | |
02/11 | 9.40 | 1.78 | 3.85 | 17.1 |
02/10 | 15.60 | 2.70 | 5.20 | 16.4 |
02/09 | 27.10 | 2.07 | 3.85 | 17.1 |
03/08 | 35.80 | 9.89 | 14.85 | 21.5 |
03/07 | 29.50 | 8.53 | 10.18 | 20.8 |
03/06 | 37.00 | 6.83 | 6.70 | 18.1 |
02/05 | 64.00 | 9.58 | 6.26 | 15.2 |
02/04 | 67.90 | 13.81 | 5.34 | 8.0 |
03/03 | -7.60 | 3.21 | 1.39 | -48.5 |
03/02 | -67.40 | 6.37 | 2.15 | -9.7 |
In fiscal year 2005 ending in February of 2004, RIMM recorded EBIT (earnings before interest and taxes) of $66.17 million. By fiscal 2011, the company had recorded EBIT of $4.64 billion. Today, the price per share of RIMM is roughly equivalent to its price per share in early 2004 although the company has increased its EBIT by a multiple of approximately 70-fold.
Such is the precarious nature of investing in high P/E stocks. The high-P/E investor is totally reliant upon the mercy of the market to maintain the peak multiple of the stock. Any negative news, a decrease in growth or even a perception that the company's products might becoming obsolete can cause the stock to plummet.
What Determines the Price Movement of a Stock?
The price of an equity moves higher in one of two ways: either the stock maintains its multiple and moves higher by increasing its earnings or the market for whatever reason, decides to assign the stock a higher multiple. Conversely, a stock moves lower when either its earnings are in decline or the market begins to assign it a lower multiple for whatever reason. The latter has been the case with RIMM as the market has been anticipating that the company’s profits and margins will begin to erode.
As Seth Klarman suggests the problem associated with buying stocks with high multiples is reflected in the fact the investor is paying a premium price. The practice contains no margin of safety. On the other hand, if the investor chooses a low multiple stock and exercises patience, the investor will likely be rewarded eventually so long as the company continues to maintain its earnings.
Typically, the market will eventually raise the multiple it is willing to pay for a stock when it becomes apparent that the companies' profits are sustainable. Secondly, if the company sustains its earnings, the shareholders will likely be rewarded in the form of dividends or buy-backs which will either return money to shareholders or provide them with a larger share of the company.
The key is determining if the earnings of the company are sustainable. In strict Grahamite terms, the value of the company will eventually be determined by its future cash flows. If the profits of the company erode, then the lower multiple is justified. If the profits are sustainable then the low multiple represents a bargain and accords the investor a substantial margin of safety.
Epilogue
RIMM stock may or may not represent value at its current valuation. If the company is able to maintain its future cash flows near its current levels, then long term investors will likely be rewarded. However, if the earnings of RIMM begin to erode in the future then the stock is probably a value trap.
Such conjecture is not the subject of today's discussion; rather the subject involves the perilous nature of investing in stocks with excessively high-P/E ratios. The number one concern for every conservative value investor should be purchasing stocks which are on sale. Stocks which are severely discounted rarely move in short order. Value investors should never expect to earn their gains quickly. If that becomes their aim then they have probably entered into the land of speculation rather than investment.
Readers who have followed my column are well aware of my reverent attitude towards patience. If I was forced to specify one essential personal attribute which trumps all other in regard to successful investing, it would be patience. Show me an individual with average intelligence and extreme patience and I will show you a successful investor. On the other hand, show me an individual with a 150 IQ and virtually no patience and you will likely be witnessing an unsuccessful speculator.
Patient investors have no reason to purchase stocks with bloated P/E multiples and that in itself is the primary reason they beat the market, at least in the longer term.
