In the beginning, I thought that it was easy to find great stocks: just find something with a good ROE and a low PE and bingo, you're a great investor.
But that's not how it works. A stock with a low PE is usually (90% of the time) cheap for some good reason. It may not be obvious at first sight and you may be tempted to buy the stock, but you should be careful. Take some time to think about it before buying it. I think that I'm giving a good advice here.
Lately, I've realized that I now respect the market a lot. The valuation given to stocks is usually correct, if we exclude the hype stocks like Shopify and Canopy Growth or some really depressed stocks that had some bad quarters in a row.
Let's take a look at two examples that explain, in my opinion, why we should most of the time respect the valuation of the market. Obviously, there's a bias there, because these are two stocks I know. But fuck, I'm doing what I can.
First example: Linamar (a cheap stock)
Share price october 2013: 34,50$
EPS 2013: 3,52$
PE 2013: 15
ROE 2013: 19
Net profit margin 2013: 9%
Share price october 2018: 61$ (currently 38$)
EPS 2018: 8,94$
PE 2018: 5
ROE 2018: 17
Net profit margin 2018: 10%
Second example: Intuit (an expensive stock)
Share price october 2013: 67$
EPS 2013: 2,83$
PE 2013: 28
ROE 2013: 27
Net profit margin 2013: 23%
Share price october 2018: 211$ (currently 263$)
EPS 2018: 4,64$
PE 2018: 41
ROE 2018: 65
Net profit margin 2018: 25%
Both are good businesses in my opinion. We can't say that Linamar (auto components) is a bad stock. It's well managed, growth has been very good so far. But it's cyclical and related to the state of the economy. However, the current PE (5) is very low and I'd be tempted, even if I respect the valuation of the market, to say that it's undervalued right now.
Intuit (tax softwares) is a great company. But I'd say that it's overvalued right now. There was a massive expansion of the PE over the last 5 years (50% higher).
However, there was a massive compression of Linamar's PE (66% drop) over the same period.
It's very strange to see that Linamar's PE has compressed that much with such EPS growth while the PE of Intuit increased a lot with a good growth, but not as spectacular as Linamar.
I don't really understand what has happened here with both stocks. But the market told us to be careful with Linamar 5 years ago and told us we could expect something good from Intuit 5 years ago (on a PE basis). That's exactly what happened.