I think a lot about the importance of valuation of stocks recently.
I wanted to analyze a bit that topic by examining two group of stocks. A group with stocks that grow well and a group with stocks that grow substantially more.
Obviously, these studies with only a few stocks imply a certain bias and they're not that scientific. However, I've chosen only top notch stocks for the two categories. I think that everybody will agree with me that the 10 stocks listed here are great companies. Of course, they're not in the same sector. But, anyway, as imperfect as it may be, here's my study.
I've compared the performance of these stocks on three different time frames:
1- For the last year (since december 6th, 2019);
2- For the last 3 years;
3- For the last 5 years.
In the first group, I've chosen 5 great canadian and american stocks. They all have a very high predictability and have been incredibly well managed in the past. Also, they all offer at least a good, but not spectacular, level of growth. Their PE has always been reasonable (mostly from 15 to 20 since the last 5 years).
Here's their performance over the last year, 3 years and 5 years:
Carmax (KMX): (1 year: 0%) (3 years: 43%) (5 years: 68%)
O'Reilly (ORLY): (1 year: 2%) (3 years: 79%) (5 years: 71%)
TJX (TJX): (1 year: 11%) (3 years: 80%) (5 years: 89%)
Metro (MRU.TO): (1 year: 3%) (3 years: 46%) (5 years: 55%)
Canadian National (CNR.TO): (1 year: 19%) (3 years: 35%) (5 years: 74%)
AVERAGE: (1 year: 7%) (3 years: 57%) (5 years: 71%)
In the second group, I've chosen 5 great canadian and american stocks. The predictability of these stocks is a little more uneven here, but it's at least OK. They've also been very well managed in the recent past. The difference here is that these stocks are much more expensive (they were always expensive over the last 5 years) but offer a much better growth.
Edwards Lifesciences (EW): (1 year: 6%) (3 years: 128%) (5 years: 218%)
Paypal (PYPL): (1 year: 107%) (3 years: 199%) (5 years: 518%)
Netflix (NFLX): (1 year: 64%) (3 years: 164%) (5 years: 304%)
Constellation Software (CSU.TO): (1 year: 16%) (3 years: 102%) (5 years: 177%)
Boyd Group (BYD.TO): (1 year: 8%) (3 years: 112%) (5 years: 216%)
AVERAGE: (1 year: 40%) (3 years: 141%) (5 years: 287%)
In each group, there's contraction or expansion of the PE ratio every year. I don't try to bet on a possible expansion of the multiple. I think that the right way to see stocks is to consider their historical PE ratio over time and to see if the current valuation is comparable or very different to the historical one and if the prospects of growth for the stock are still there. For instance, in the second group, the PE ratio has always been high for Paypal. Does the growth prospects for that stock are still there? I'd say yes without hesitation. Of course, some bad results would affect the stock as it is "priced for perfection" like some may say. But, is it really less risky to buy cheap stocks like Linamar or Home Capital Group? Even with a small PE ratio, we have seen a drastic contraction of their PE in the past.
So, in my opinion, it's not riskier to buy expensive stocks, as long as their high valuation has always been high and their results still match their valuation. Of course, buying just one of these stocks, for a big position of your portfolio, is not a good idea. But if you buy 10 of these stocks, I'd bet that you'll beat the market by an appreciable margin, in a bull or bear market.
With the first group, you would have had a performance of 71% for the last 5 years. It's a good performance, but with the second group, you would have got a 287% performance.
Imagine the impact of such a performance on a 100 000$ or 1 million $ portfolio. Or just imagine that impact on your portfolio, as small or big as it may be.