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To Avoid Big Losses, You Have To Buy At The Right Price

July 14, 2014 | About:

To Avoid Big Losses, You Have To Buy At The Right Price

There are all sorts of ways to make mistakes when buying stocks. We can buy the stock of a bad business with poor products. We can buy the stock of a business with a product that becomes obsolete. We can even buy stock in a well-run company in an ultra-competitive industry that doesn’t allow for decent margins. Or, we can make one of the most common mistakes that I hear about others making and buy stock in a very good, or even great business, but pay too high of a price based upon the fundamentals of the business. While this situation does not preclude our making a profit from the investment, it simply means our returns will be far lower than they would have been if we had been patient and waited for the opportunity to buy it a price at or below fair value.

This is actually a very easy mistake to make. The most exciting stocks to own are the ones you hear being discussed in the financial news and the stocks our friends are all talking about. We see and hear the analysts making the case that this stock is a must own and justifying the high price against the fundamentals. Rather than getting caught up in the emotion and excitement of this type of situation, we must realize that the story we are hearing from others is merely the explanation for what has already occurred; a high share price. The question we must always answer for ourselves is what will drive the share price higher from this level and when will it happen?

In this, the fourth and final installment in this series on avoiding big losses, I will examine what appears to be an excellent business proposition and a well-run company but is currently trading at a valuation that will, at some point, cause it to deliver returns far below the expectations of shareholders. What most investors fail to appropriately consider in this type of situation are the various ways this under performance of the share price might manifest itself.

The Greatest Danger Of Good Businesses That Are Overpriced

I think that good businesses that are overpriced pose the greatest threat to investors precisely because they are such good businesses. It is always easy for us to analyze the business itself and understand all of the reasons we should own it. All of the good reasons to own the business tend to distract our attention away from the fact that the price is too high.

In many cases, these valuation issues are resolved relatively quickly when the company reports a quarterly earnings miss and investors sell their shares in absolute panic at any price. These situations are great for value investors as the market tends to move in extremes in both directions. When investors are excited, the prices run higher to extreme levels and when investors panic, the prices tend to fall to extreme levels. If you are one of the unfortunate people holding shares in this type of situation, it can created a horribly traumatizing experience; they type of experience that drives people away from the market for years. Many shareholders will try to hang on through the pain because they are convinced of the value of the business. Once the pain of continuing losses becomes too great; they finally give up and sell at any price someone will pay. When the last person who owns the stock is finally giving up and selling the shares of a good business, that is the perfect time for the value investor to buy.

The more insidious and less frequent way stock prices move from vastly overvalued to fair market of cheap valuations is through an extended period of underperformance. In these situations, existing shareholders are reluctant to sell shares because the price might well continue to move in their favor but it simply underperforms the market over several months or years. I refer to this situation as insidious because investors holding the shares believe they are doing well in many cases but just don’t realize that they should be doing better. If you are losing 2% a year in portfolio performance because of having bought at the wrong price on a consistent basis, over a 30-year period, the difference in return on a $10,000 investment would total $18,113.62. A small 2% difference doesn’t look so small over time, does it?

Even though the long-term impact of this situation is horrible, many investors experience it throughout their investing experience without ever realizing it has happened. That is why I call it insidious; it happens with such subtlety that it often goes completely undetected.

How Do We Avoid This Situation?

This is the classic application of the old adage: “Easier said than done.” The simple answer is that we should never overpay for our long positions in stocks. This can be really tough to do when surrounded by the hype and excitement that is typically involved in the high-flying momentum stocks. When the underlying business appears to be solid and well-run, it makes resisting even more difficult. That is why value investors like to stay focused on fundamentals and core values.

Ctrip.com International, Ltd. (CTRP) looks as though it might be an excellent current example of a good business that simply has been priced by investors at a level that is going to result in some pain for shareholders in one way or another.

Ctrip.com is in the business of arranging travel and lodging for clients planning trips to China. This is an excellent business niche and truly fills a need because these arrangements can be a real pain if you don’t know what you are doing and with whom you are dealing. Travel to China is a growing industry with increasing demand so the core demand appears to be solid and assured for a long time to come.

The business is profitable and both sales and profits are rising at a fairly rapid pace and analysts are expecting the company to expand its earnings at an annual clip of 18.3%/year over the next five years.

In terms of three of my favorite metrics, return on equity, assets and capital, this business leaves nothing to complain about with 5-year annual returns of 18.1%, 12.3% and 16.7% respectively. These are all numbers that get my attention and start my mouth watering. They are the kind of numbers that I get excited about and they represent world-class results.

However, upon further investigation, potential issues appear on the valuation side of the equation. This business is currently priced at an astounding 88.53 times projected 2014 earnings and 48.9 times projected 2015 earnings.

The business runs into more valuation headwinds in terms of its price to book valuation of 5.98 and its price to cash flow ratio of 23.7. Just for good measure, we can also take a glance at the 10.1 price to sales valuation and you start to get the idea and my basic point.

This appears to be a very good business in a very interesting market niche. It also appears to be seriously overpriced.

But don’t think for one moment that the 12 of the 13 professional analysts covering this stock are going to let an excessive valuation stand in their way. 9 of these analysts currently rate this stock as a “strong buy” with another rating it as a “moderate buy”. Two more of the analysts rate the stock as a “hold” and only one rates the stock as a “moderate sell”.

Final Thoughts And Conclusions

Even for a hard-core value investor, most of us allow some leeway in our value calculations when we believe it is warranted in a certain situation. That is the case in my assessment of Ctrip.com. I think this business is well positioned for continued growth in sales and earnings. I also believe the industry in which it functions has a bright long term future and I understand that those beliefs deserve a premium valuation compared to my normal bargain basement mentality.

Due to the fact that I find this business niche so attractive, I am willing to assign a valuation to it of 25 times the analysts’ consensus earnings estimate for 2015. For me, this is almost an unheard of valuation at which I am willing to buy but I see the future growth opportunity as being so attractive that I am willing to reach a bit to get this one. This metric would price the business at $30.75/share. Considering the current share price is slightly over $60, it might well be that I will never own its shares; I can live with that. I see my offering price as very aggressive but believe the business justifies an aggressive offer.

I don’t believe any business deserves to be priced at three times its projected growth rate based upon next year’s earnings and I will not pay it under any circumstances. You shouldn’t either if you want to be a successful investor over the long term. Buying good businesses is a non-negotiable in my world. Buying them at the right price is as well. Anyone who doesn’t believe Ctrip.com can fall by 50% would have probably said the same thing about Apple (APPL) a couple of years ago as well.

About the author:

Ken McGaha
Ken McGaha has been managing his own investment portfolios for over 20 years. On July 20, 2012 he launched the Self-Made Millionaire Tracking Portfolio with a portion of his capital as an aid to teach younger members of his extended family how he built his own investment portfolios and maintains them today.

Ken's Self-Made Millionaire website now has subscribers in at least 13 countries and the Self-Made Millionaire Tracking Portfolio has delivered a 28.36% annualized rate of return on capital between July 20, 2012 and June 21, 2014.

In late December of 2013, Ken added the Maggie's Money Mountain Tracking Portfolio to his website to show young investors with limited capital how he would invest and trade an account with $4,500 in order to grow it at a compounded rate of 12% annually. From December 30, 2013 through June 21, 2014, this account has produced an actual return of 26.05%.

Visit Ken McGaha's Website


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