Sometimes It's OK To Pay More
A farmer once told me that if a feed store replaced the word "cattle" on a bag of fodder with the word "horse," it could bump up the price by 30%, even though the contents hadn't changed.
Maybe he was right, maybe not. But haven't we all seen the power of perspective in action? You purchase a television or a pair of shoes, paying extra for a brand you trust, only to find the quality of that brand has eroded over time until the product is no better than the rest. Or maybe the quality edge never existed, and the brand premium was created out of the air by shrewd marketing.
Those two factors — reversion to the mean and the myth of superiority — explain some of the risks inherent in buying stocks that trade at a premium. Stocks with low valuations tend to outperform those with high valuations, and we at the Forecasts love a good bargain.
However, some products — like some companies — are simply better than the alternatives. There's a reason we don't eat fast food for every meal. Sure, it costs less and takes less time, but sometimes we're willing to pay up for quality and dine at a fancy restaurant. Unfortunately, paying extra for a stock may leave you with a bad taste in your mouth.
Throughout the 1980s and 1990s and well into the 2000s, Coca-Cola ($44; KO) and its global brand fetched a premium price. During the 1990s, Coca-Cola averaged a price/earnings ratio of 33, versus 24 for rival PepsiCo ($98; PEP). Coke delivered higher annualized profit growth (12% to Pepsi's 7%) and price gains (503% to 230%). Then, in the 2000s, the game changed. Coke's profit growth and price returns lagged Pepsi, but for much of the decade Coke commanded a higher P/E, supported by shadows of past superiority.
The story here isn't why Pepsi waxed and Coke waned, but a warning that investors should look past big brands or big hype when considering stocks at above-market prices.
Regardless of the reason for the higher valuation, many stocks that trade at a premium hold onto that premium over time. Of the 197 S&P 1500 Index stocks that traded at least 10% above their industry average in 80% of the months over the last five years, less than one-third currently trade at a discount.
Superior growth explains part of that trend. Consistently expensive stocks average Quadrix Momentum scores of 60. In contrast, stocks that traded at a premium less than 20% of the time average Momentum scores of 50. Momentum scores reflect recent operating results.
Only three of our recommended stocks have traded at least 10% above their industry average P/E at least 75% of the time over the last five years. Two of those stocks are currently available at a discount — B/E Aerospace ($78; BEAV) and EMC ($30; EMC).
Cheaper stocks look like better investment options, on average. Our growth-at-a-good-price investment approach tends to put us in solid growers that trade at discount valuations. Of the 37 stocks on our buy lists, 84% have a price/earnings ratio below the average for their industry. Those discounts average 27%.
In our view, stocks trading above the industry norm have more to prove. Be picky in this area. We currently recommend four stocks currently trading above their industry average P/E ratio:
• Apple ($115; AAPL)
• Comcast ($54; CMCSa)
• Southwest Airlines ($39; LUV)
• Union Pacific ($121; UNP)
All four enjoy superior growth potential, an attractive market position, or both. Not to mention high Quadrix scores, which reflect solid fundamentals.