Sometimes You Get What You Pay For

Relevant article for some of our highflyers :

Suppose that we put $10,000 into your pocket and teleport you back in time, onto the floor of the NYSE at 1PM on Thursday, October 3, 1974. You know what you know now, and you can buy whatever stock you want to buy. When the market closes, we’re going to teleport you back to the present, and your $10,000 investment will have turned into whatever it would have turned into, from then until today.

What are you going to buy? If you’re smart, you’re obviously going to buy $WMT–as much of it as you possibly can. You haven’t looked at any other names, therefore you can’t be sure of their performance. Exxon? Coca-Cola? You would equal perform the market. IBM? You would dramatically underperform. The only present-day blue-chip company that I can think of that would have even come close to matching Wal-Mart’s performance is Walgreen (WAG: NYSE). In $WAG, a $10,000 investment in 1974 would have turned into $10,000,000.

Now, what is the maximum price that you should be willing to pay for $WMT, knowing what it’s going to become? And what sort of valuation would this price imply? One way to answer the question would be to discount $WMT’s total return from 1974 to today at the rate of return of the overall market. $WMT at $12 produced a 40 year annual total return of 23%. It turns out that the price that would bring this return down to the market rate, 12%, is roughly $600.

In 1974, $600 for a $WMT share would have represented a PE ratio of more than 600. In the current market, which is much richer, this would be the equivalent of something like 1500 times trailing earnings–again for a company with undistorted earnings that has been in operation for decades.

To account for risk and uncertainty, which doesn’t exist for you, but does exist for anyone that’s not traveling through time, suppose that we cut our $600 maximum fair price for $WMT by 90%. Then we cut it in half. Then we cut it in half again. Normalized to the 2014 market, the multiple would still be roughly 40 times earnings. Many people would balk at such a “rich” price–but for $WMT, it arguably would have been, and arguably actually was, the single greatest buying opportunity of that generation.

The next time we see an excellent business trading at 40 times earnings, or 75 times earnings, or 100 times earnings, or wherever, and we shy away, it might help to remember the example of Wal-Mart. High multiples can be entirely justified, provided that the growth potential is real. We definitely should remember the example if we ever come under the temptation to short individual names based on valuation concerns. Nothing is riskier or more imprudent than to short a high-quality business with an uptrending stock price, simply because we think the price is too high. It can always go higher–often, it will go higher, for fundamentally valid reasons that we’ve failed to appreciate.

Ultimately, the market has to do what we just tried to do above–figure out how to price the obvious superstars of the future, not for next year, but for the next forty years. And so we should give it some slack when we see it catapult the $TSLA’s, $AMZN’s, and $FB’s of the world to valuations that make us uncomfortable. Depending on how things turn out, those valuations may prove to have been cheap.

As investors, we intuitively conceptualize the P/E ratio as a measure of how much “upside” a stock has, how much juice is left in the can. This is pure anchoring bias–we envision the expansion of the multiple as the ultimate source of our return. If we’re long-term investors, the ultimate source of our return will be the growth that the company generates in its business–not in one year, but over it’s entire lifetime. And so a stock priced at a high multiple can be overflowing with juice left in the can, if the potential to grow is there. It can be a screaming bargain, just as $WMT was.


Hindsight is 20/20. This article has cherry-picked the best performing stock and then argues (it seems) that it is ok to pay sky high valuations for companies. Who could have known that Walmart would turn into the company that it is today? Forty years Walmart was still extremely risky and it’s future was far, far from set. I wonder how a portfolio that invested in all high P/E companies would have performed compared to the market or better yet compared to Saul’s investment philosophy. Saul is up about 140x over 23 years and if the next 17 years follow the same returns then he will by far exceed the 1000x return that Walmart achieved in 40 years…and with much, much lower risk. I think that it is extremely foolish to invest a large portion of one’s capital in extremely high P/E companies.



I agree with you Chris. Most high-flying stocks will wilt at some point, very few will bloom into a WMT. TMF has proven itself adept at picking more of the latter than the former, but obviously this performance cannot be generalized across high PE stocks in general.