Warren Buffett (Trades, Portfolio) has famously said that he'd rather pay a premium price for a high-quality company rather than a low price for a struggling business.
This concept has now become the prevailing view on Wall Street. Investors and analysts have been happy to buy and reccomend stocks at high prices using the quality label as justification.
I think that there's also a strong case to be made that, in some cases, investors and analysts are now taking a step back from valuation, constructing a quality story around a high price rather than computing a valuation based on fundamentals.
Overpaying for quality
Overpaying for growth and quality is something all investors should be aware of. Just because a business is the best in the world at what it does, it does not necessarily mean that it's worth an infinite price.
This is something Buffett discussed at the 1997 Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) annual meeting of shareholders. A shareholder asked Buffett about his opinion on the level of the market at the time, especially in regards to the companies that he labeled as the "Ineviables." Buffett described these "ineviables" in Berkshire's 1996 annual report:
"Companies such as Coca-Cola and Gillette might well be labeled "The Inevitables." Forecasters may differ a bit in their predictions of exactly how much soft drink or shaving-equipment business these companies will be doing in ten or twenty years...In the end, however, no sensible observer - not even these companies' most vigorous competitors, assuming they are assessing the matter honestly - questions that Coke and Gillette will dominate their fields worldwide for an investment lifetime.""
Here's what Buffett had to say on that above-mentioned investor's question at the 1997 Berkshire annual meeting of shareholders:
"Because what I was doing in the annual report is I had talked about Coke and Gillette as being "The Inevitables," and what wonderful businesses they were.
And I thought it appropriate, particularly — the report goes to a lot of people — that they would not take that as an unqualified buy recommendation about the companies, because they're absolutely wonderful companies run by outstanding managers. But you can pay too much, at least in the short run, for businesses like that.
So I thought it was only appropriate to point out that no matter how wonderful a business it is, that there always is a risk that you will pay a price where it will take a few years for the business to catch up with the stock. That the stock can get ahead of the business.
But I didn't want — particularly — relatively unsophisticated people to see those names there and then think, "This guy is touting these as a wonderful buy."
Don't blindly invest
Buffett has tried to make it clear many times in the past that investors should always understand valuation first before they start investing, and not just follow tips blindly.
This advice is a continuation of that. If you don't understand how to value a business based on fundamentals and instead only buy stocks based on tips, you are destined to hit a speed bump at some point.
Paying any price because a stock looks like a great business will lead to similar problems. It is better to wait for the market to give you a better price. After all, the market is there to serve investors, not lead us.
Disclosure: The author owns shares in Berkshire Hathaway.
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