Most of us know that a stock with a high valuation has a higher risk of loss if the company dissapoints in terms of earnings. However i think there is an additional factor to consider when investing in a stock which is fully valued. A stock which is fairly valued has already discounted a bright future. When i think of investing in such a stock, my due diligence has to be deeper. I should have a strong reason to believe that the company has an even brighter future than what the market believe. What that means is that i am looking into the future farther for the company
Let me illustrate –
Company A sells at 12 times PE. If the ROE is around 15%, then the stock is discounting a mere 3 years of growth of 10 %.
In contrast company B sells at 30 times PE. If the ROE is 15%, then the stock is already discounting a growth of 15% for 10 years.
For me to make money on stock B, i need to have the foresight that the company do better than what the market has discounted. That means the company has to grow faster than 15% or for longer. Both cases for stock B are not easy to forecast .
In contrast company A has to perform only a bit better to give me good returns.
Now all of the above is basic value investing and concept of margin of safety. however my thought is that for high PE stock i should have a deep understanding of the business , its competitive position and other factors. Also my margin of error is smaller for such stocks. If an unknown factor works against the company, then there could be a permanent loss of capital. In contrast low valuation stocks need only a few things to go right for me to come out ahead.
In a nutshell, a low valuation stock protects me from my own shortcomings and sometimes I can get away with lesser research.
Stocks in the real estate business, telecom and retail come to my mind when I think of fairly valued company. When I look at these companies, the thought which comes to my mind is whether these companies will do better than what the market expects and does my own research substantiate it?