Value Comes at a Price

It’s far better to buy a wonderful company at a fair price than a fair
company at a wonderful price.
—Warren Buffett

W hen you think of value in the traditional sense, bargains

immediately spring to mind: something once priced higher
now is priced lower. It seems logical. Growth stock investing, however, can
turn this definition on its head. In the stock market, what appears cheap
could actually be expensive and what looks expensive or too high may turn
out to be the next superperformance stock. The simple reality is that value
comes at a price.

The P/E Ratio: Overused and Misunderstood

Every day, armies of analysts and Wall Street pros churn out thousands
of opinions about stock values. This stock is overvalued; that one is a bar-
gain. What is the basis of many of these valuation calls? Often it’s the price/
earnings ratio (P/E), a stock’s price expressed as a multiple of the compa-
ny’s earnings. A great amount of incorrect information has been written
about the P/E ratio. Many investors rely too heavily on this popular formula
because of a misunderstanding or a lack of knowledge. Although it may
come as a surprise to you, historical analyses of superperformance stocks
suggest that by themselves P/E ratios rank among of the most useless sta-
tistics on Wall Street.
 The standard P/E ratio reflects historical results and does not take into
account the most important element for stock price appreciation: the future.
Sure, it’s possible to use earnings estimates to calculate a forward-looking
P/E ratio, but if you do, you’re relying on estimates that are opinions and
often turn out to be wrong. If a company reports disappointing earnings
that fail to meet or beat the estimates, analysts will revise their earnings pro-
jections downward. As a result, the forward-looking denominator—the E in
P/E—will shrink, and assuming the P remains constant, the ratio will rise.
This is why it’s important to concentrate on companies that are reporting
strong earnings, which then trigger upward revisions in earnings estimates.
Strong earnings growth will make a stock a better value.

Bottom Fishers’ Bliss

Some analysts will recommend that you buy a stock that has had a severe
decline. The justification may be that the P/E is at or near the low end of its
historical range. In many instances, however, such price adjustments antici-

Figure 4.1 American Intl Group (AIG) 1999–2000

pate poor earnings reports. When quarterly results are finally released and
a company misses analysts’ estimates or reports a loss, the P/E moves back
up (in some cases it skyrockets), which may cause the stock price to adjust
downward even further. This was the case for Morgan Stanley (MS/NYSE)
in late 2007. The stock price fell and drove the P/E to a 10-year low. Morgan
later reported disappointing negative year-over-year earnings comparisons,
and the P/E ratio promptly soared to more than 120 times earnings. With
earnings deteriorating and the stock selling at a P/E of 120, the stock was
suddenly severely overvalued. The share price plunged even further to under
$7. The cause of Morgan Stanley’s decline was an industrywide financial cri-
sis, and by 2008 the P/E ratios of Bank America, Citigroup, and AIG all hit
10-year lows, along with those of many others in the banking and financial
sector. Within 12 months, all three stocks plunged more than 90 percent.

The Cheap Trap

Buying a cheap stock is like a trap hand in poker; it’s hard to get away from.
When you buy a stock solely because it’s cheap, it’s difficult to sell if it moves
against you because then it’s even cheaper, which is the reason you bought it
in the first place. The cheaper it gets, the more attractive it becomes based on
the “it’s cheap” rationale. This is the type of thinking that gets investors in
big trouble. Most investors look for bargains instead of looking for leaders,
and more often than not they get what they pay for.

Don’t Pass on High P/E Stocks

It is normal for growth stocks to fetch a premium to the market; this is espe-
cially true if a company is increasing its earnings rapidly. Shares of fast-growing
companies can trade at multiples of three or four times the overall market. In
fact, high growth leaders can command even higher premiums in times when
growth stocks are in favor relative to value stocks. Even during periods when
growth is not in favor, they can sell at a significant premium to the market.
In many cases, stocks with superperformance potential will sell at what
appears to be an unreasonably high P/E ratio. This scares away many ama-
teur investors. When the growth rate of a company is extremely high, tradi-
tional valuation measures based on the P/E are of little help in determining
overvaluation. However, stocks with high P/E ratios should be studied and
considered as potential purchases, particularly if you find that something
new and exciting is going on with the company and there’s a catalyst that
can lead to explosive earnings growth. It’s even better is if the company or its
business is misunderstood or underfollowed by analysts.
Internet providers were a great example. When Yahoo! was at the fore-
front of one of the greatest technological changes since the telephone, I was
asked in a television interview if I thought the Internet would survive. Can
you imagine the Internet failing to exist? Not today. But in the early to mid-
dle 1990s you might have had a different view, as many did. That period was
precisely when Internet technology stocks were making new 52-week highs
and trading at what appeared to be absurd valuations.
Most of the best growth stocks seldom trade at a low P/E ratio. In
fact, many of the biggest winning stocks in history traded at more than
30 or 40 times earnings before they experienced their largest advance. It
only makes sense that faster-growing companies sell at higher multiples
than slower-growing companies. If you avoid stocks just because the P/E or
share price seems too high, you will miss out on many of the biggest market
movers. The really exciting, fast-growing companies with big potential are
not going to be found in the bargain bin. You don’t find top-notch mer-
chandise at the dollar store. As a matter of fact, the really great companies
are almost always going to appear expensive, and that’s precisely why most
investors miss out.

High Growth Baffles the Analysts

You might recall when Mark [Minervini] was here last in mid-
October [1998] he recommended Yahoo!, which is up 100 percent
since then. . . .
—Ron Insana, CNBC interview, November 1998
Wall Street has little idea what P/E ratio to put on companies growing at
huge rates. It’s extremely difficult, if not impossible, to predict how long a
growth phase will last and what level of deceleration will occur over a par-
ticular time frame when one is dealing with a dynamic new leader or new
industry. Many superperformance stocks tend to move to extreme valua-
tions and leave analysts in awe as their prices continue to climb into the
stratosphere in spite of what appears to be a ridiculous valuation. Missing
out on these great companies is due to misunderstanding the way Wall Street
works and therefore concentrating on the wrong price drivers.
In June 1997, I bought shares of Yahoo! when the stock was trading
at 938 times earnings. Talk about a high P/E! Every institutional investor I
mentioned the stock to said, “No way—Ya-WHO?” The company was vir-
tually unknown at the time, but Yahoo! was leading a new technological
revolution: the Internet. The potential for what was then a new industry
was widely misunderstood at the time. Yahoo! shares advanced an amazing
7,800 percent in just 29 months, and the P/E expanded to more than 1,700
times earnings. Even if you got only a piece of that advance, you could have
made a boatload.

Figure 4.2 Yahoo (YHOO) 1997–1999

What’s High? What’s Low?
Jan. 9 Minervini bought Taser (TASR/Nasdaq), a company that
makes Taser guns—nonlethal weapons for police departments. He
spotted its potential using his proprietary methodology, “Specific
Entry Point Analysis” (SEPA). He then rode the stock up 121% in
only six weeks.
—BusinessWeek Online, May 10, 2004

Everybody knows the old adage “buy low and sell high.” It makes sense—
like going to a store to find something on sale. However, buying low and
selling high has little to do with the current stock price. How high or low
the price is relative to where it was previously is not the determining factor
in whether a stock will go higher still. A stock trading at $60 can go to $260,
just as a stock trading at $2 can go to $1 or even to $0. Was Yahoo! too high
when it boasted a P/E ratio of 938? How about TASER (TASR/NASDAQ)
in January 2004, just before it advanced 300 percent in three months; was it

Figure 4.3 TASER Intl. (TASR) 2004

Figure 4.4 TASER Intl. (TASR) 2004
TASER emerged from a tight four-week consolidation.

too high trading at a P/E ratio of more than 200 times earnings? Conversely,
AIG appeared to be a bargain when its P/E hit a 10-year low in early 2008;
the stock fell 99 percent before the year was finished.

There’s a Reason a Ferrari

Costs More Than a Hyundai
If you want to buy a high-performance car such as a Ferrari, you’re going to
pay a premium price. The same thing applies to high-performance stocks.
The top 100 best-performing small- and mid-cap stocks of 1996 and 1997
had an average P/E of 40. Their P/Es grew further to an average of 87 and
a median of 65. Relatively speaking, their initially “expensive” P/Es turned
out to be extremely cheap. These top stocks averaged a gain of 421 percent
from buy point to peak. The P/E of the S&P 500 ranged from 18 to 20 dur-
ing that period.
Figure 4.5 CKE Restaurants (CKR) 1995
On October 13, 1995, CKR emerged into new high ground trading at a 55x
earnings.

Figure 4.6 CKE Restaurants (CKR) 1998

From the point CKR emerged into new high ground on October 13, 1995, the
stock advanced more than 400% in 28 months, but the P/E ratio fell because
earnings grew even faster.
 Value investors often shy away from stocks with high price/earn-
ings multiples. They won’t touch a stock whose P/E is much higher than,
say, that of the S&P 500 index. Savvy growth players know that you often
have to pay more for the best goods in the market. Consider the example
of CKE Restaurants, which sported a relatively high P/E just before the
stock price took off. CKE Restaurants emerged into new high ground in
extremely fast trading on October 13, 1995. Right before its breakout, the
stock had a P/E of 55, or 2.9 times the S&P’s P/E of 18.9. The company had
scored triple-digit profit growth in the two most recent quarters. Analysts
saw the operator of Carl’s Jr. burger shops increasing profit by a whop-
ping 700 percent from year-ago levels in the upcoming quarter. The stock
climbed for 103 weeks. It finally peaked near $41 in October 1997 for a
412 percent gain. During its price advance, CKE averaged a spectacular
175 percent growth in earnings from 1995 to 1997. Its P/E fell to 47, or 1.8
times the P/E of the S&P.

Apollo Group (APOL)

Most of the time money in stocks is lost not because the P/E was too high
but because earnings did not grow at a high enough rate to sustain expecta-
tions; the growth potential of the company was misjudged. The ideal situ-
ation is to find a company whose growth prospects warrant a high P/E: a
company that can deliver the goods—and the longer it can maintain strong
growth, the better.
Consider the example of Apollo Group. From mid-2001 through 2004,
the P/E ratio for Apollo was virtually unchanged despite a 200 percent rally
in the price of the stock. Why did the P/E remain at the same level as it
was several years earlier even though the stock price soared? Because earn-
ings kept pace with the stock’s price appreciation. If a company can deliver
strong earnings as fast as or even faster than its stock price appreciates, an
initial high valuation may prove to be very cheap. Apollo Group went pub-
lic in December 1994 with a market value of only $112 million. Apollo met
or beat Wall Street estimates for 45 consecutive quarters. As you can prob-
ably imagine, this led the company’s stock price to superperformance status.
Figure 4.7 Apollo Group (APOL) 1999–2004
In 2001 APOL was trading at 60x earnings; by 2004 the price advanced 200
percent, but the P/E ratio remained at 60x due to earnings growth keeping pace.

From 2000 to 2004, Apollo Group’s stock advanced more than 850
percent. During the same period, the Nasdaq Composite Index was down
60 percent.
Crocs Mania
As the plastic clogs originally meant for gardeners and boaters became a
fashion rage, everybody started wearing Crocs, and the popularity spilled
over into the stock. Crocs (CROX/NASDAQ) shares boasted a P/E of more
than 60 times earnings, before the price blasted higher. But fads come and
fads go, and perhaps the world is finding that when it comes to Crocs, the
shoe no longer fits. The P/E ratio for Crocs contracted from April 2006 to
October 2007 as earnings grew faster than the stock’s price appreciation.
If you had bought Crocs when shares were trading at more than 60x earn-
ings—the most expensive P/E in its history—you could have reaped a return
of 700 percent on your money in only 20 months. If you had waited for the
stock to trade at a more reasonable valuation and bought when the stock
traded near its historical low P/E, you would have lost 99 percent of your
capital in less than a year. Regardless of one’s opinion, the market always has
the last word.

Figure 4.8 Crocs (CROX) 2006–2008