Don't be afraid to Pay Up for Quality!
Don't be afraid to Pay Up for Quality!
Figuring out the “right” price to pay for a stock is one of the toughest parts of investing. We all want to buy stocks at a discount, a bargain price, with a hefty margin of safety. However, this search for bargain stocks can often lead to missed opportunities. There’s also the case of price anchoring that often derails investors. Once you do determine a fair price, or at the very least a reasonable price you are willing to pay for a given stock, if the price moves higher we often stop buying more shares because the price may be outside our fair range. We tell ourselves that we will wait for the next market correction to top off our position. But there’s no guarantee the share price will ever revert back to the original level at which you purchased your initial shares. After all, the intention of investing is for our investment to appreciate in value. Hence by price anchoring or waiting for corrections we inevitably anticipate the market to do the exact opposite of what we ultimately expect from the market. Quite the conundrum.
In my opinion, investors would be better off focusing more on business quality than valuation. In the long term, what will drive your returns is how fast the business can grow, not whether you initially bought it at a bargain price or a high price. That being said, valuations still do matter, and they can earn you higher returns if you get them right.
Let me show you an example where quality and business growth trumped valuation. And a method you can use to justify paying “more expensive” prices for potentially “better” opportunities.
But first let me ask you a question. Which of these 3 stocks do you think it was better to buy in 2009.
Johnson & Johnson (JNJ)
Visa (V)
UnitedHealth Group (UNH)
You might want to ask at what price?
Well, buying JNJ at its lowest price in 2009 would have led to a total return of 390.52%. That’s pretty solid, an almost 4X multiple on your original investment.
Buying V at its absolute highest price possible in 2009 would have led to a total return of 1,256.50%. That’s pretty phenomenal, a 12.5X multiple on your original investment.
And buying UNH at its absolute highest price possible in 2009 would have led to a total return of 1,781.69%. A nearly 18X multiple, and considerably better than V and much more so than JNJ.
Clearly V and UNH have grown at a much faster pace than JNJ since 2009, and returns for both stocks reflect that growth. But how could you have possibly known this back in 2009. The answer is you couldn’t have know for sure, but you could have made an assumption about each of these 3 companies.
V at its peak in 2009 was trading for a P/E multiple of 25.06, while JNJ had a P/E multiple of 7.87 at its lowest point. From a P/E valuation perspective JNJ presented a much more attractive valuation, nearly 4 times cheaper than V.
While JNJ grew its earnings by 9% in the following year, V grew its earnings by 32.5%, a little more than 3 times faster.
If you rely on using P/E multiples a good tool to add to your tool bag is the PEG ratio. The PEG ratio includes the estimated rate of future earnings growth and it can help you determine if paying a “higher” price for a stock that is expected to grow faster is more justifiable opposed to buying the “cheaper looking” stock.
In 2010 these 3 stocks had the following PEG ratios.
JNJ - 0.68
V - 0.63
UNH - 0.28
Based on P/E ratio alone, JNJ looked much cheaper than both V and UNH. But based on the PEG ratio, both V and UNH appeared to be more attractive opportunities. What I haven’t told you is that the PEG ratio above for JNJ was from its lowest price point in 2010. While the PEG ratios for V and UNH were from their highest price point in 2010. So even on their most expensive day in 2010, both V and UNH appeared “cheaper” than JNJ on its least expensive day.
Every year between 2008 and 2019, buying UNH at its highest price during each year would have led to better long term returns than buying JNJ at its lowest price, if the position was held through 6/12/24. The same holds true for V.
This statistic doesn’t hold true for V in 2020 and 2024. And it doesn’t hold true for UNH since 2020. However, I believe that in due time both V and UNH will deliver better returns than JNJ, simply because both companies are still expected to grow at a faster pace than JNJ.
As of 6/12/24 JNJ has a PEG ratio of 1.81. While V has a PEG ratio of 1.82 and UNH of 2.21. Even though V has a P/E ratio more than double JNJ’s P/E ratio and UNH nearly triple the ratio. Based on the PEG ratio both stocks look just as attractive.
An attractive PEG ratio is a ratio that is lower than 1.00, from that perspective neither of these 3 stocks looks “cheap” today.
Many investors will shy away from a stock with a high P/E ratio or one that is trading near its 52-week high. But as a long term investor that intends to hold their positions for decades, buying the “more expensive” stock that has the potential to grow at a faster pace, can often times be the wiser option.
The one caveat of the PEG ratio is that it is based on the expected rate of earnings growth. A very important question you have to ask yourself before you rely on this ratio to drive your decision, is whether the expected rate of growth is attainable for the company.
My analysis here can be considered cheating since I am using data points that have already occurred. It’s easy to look back at historical data and calculate precise returns and ratios. Investing for the future based on assumptions and expectations is a bit more challenging.
If you want to screen for stocks with a low or reasonable PEG ratio you can do so on the finchat.io stock screener