Most of us know that a stock with a high valuation has a higher risk of loss if the company dissapoints in terms of earnings. However i think there is an additional factor to consider when investing in a stock which is fully valued. A stock which is fairly valued has already discounted a bright future. When i think of investing in such a stock, my due diligence has to be deeper. I should have a strong reason to believe that the company has an even brighter future than what the market believe. What that means is that i am looking into the future farther for the company

Let me illustrate –

Company A sells at 12 times PE. If the ROE is around 15%, then the stock is discounting a mere 3 years of growth of 10 %.

In contrast company B sells at 30 times PE. If the ROE is 15%, then the stock is already discounting a growth of 15% for 10 years.

For me to make money on stock B, i need to have the foresight that the company do better than what the market has discounted. That means the company has to grow faster than 15% or for longer. Both cases for stock B are not easy to forecast .

In contrast company A has to perform only a bit better to give me good returns.

Now all of the above is basic value investing and concept of margin of safety. however my thought is that for high PE stock i should have a deep understanding of the business , its competitive position and other factors. Also my margin of error is smaller for such stocks. If an unknown factor works against the company, then there could be a permanent loss of capital. In contrast low valuation stocks need only a few things to go right for me to come out ahead.

In a nutshell, a low valuation stock protects me from my own shortcomings and sometimes I can get away with lesser research.

Stocks in the real estate business, telecom and retail come to my mind when I think of fairly valued company. When I look at these companies, the thought which comes to my mind is whether these companies will do better than what the market expects and does my own research substantiate it?

I generally analyse a good number of companies before investing in a few. A lot of times i am not able to figure out, with reasonable confidence, the range of intrinsic value estimates for the company. I have had this problem with telecom, retail companies etc. These are companies in a new, sunrise industry. There is a lot of promise and enthusiam around the companies and the valuations may reflect that. I do not have a doubt that these companies and industries will do well. The problem for me is figuring out how well, and how much of that is already built into the stock price.

On the other end are companies which are essentially conglomerates or a combination of businesses such as Reliance, IOC etc. These are in mature industries and are good companies. They may very well be undervalued. The problem for me is that they have a lot of moving parts. IOC has a 400 page annual report, relaince has (or used to have) a lot smaller businesses such as telecom, asset management and now retail etc. So analysing these companies would mean taking apart each of the sub-businesses, valuing each of them separately and then arriving at the whole value. Impossible …no, but definitely tough and a lot of work.

Compare that to the simple (as least to me) businesses such as castrol (lubes), Lanxess ABS(ABS), marico (FMCG), asian paints (paints), concor etc. I could go on and on. These companies are engaged in a single line of business, nationally or in some cases in international markets. They have a decent operating history, dominant position in a stable market, and in some cases attractive valuations. To boot, some even have a small annual reports to analyse (just joking!).

I have invested in both the complex and in the simple businesses (avoided the sunrise type industry as I don’t have a better idea of these businesses). Overall, I found that the simple businesses are easier to understand, to follow on a regular basis and in the end give good returns.

I am clearly influenced by the following quote by warren buffett

“Investors should remember that their scorecard is not computed using Olympic-diving methods: Degree-of-difficulty doesn’t count. If you are right about a business whose value is largely dependent on a single key factor that is both easy to understand and enduring, the payoff is the same as if you had correctly analyzed an investment alternative characterized by many constantly shifting and complex variables.”

So if I have an option between a diffcult to understand, complex conglomerate and a simple business(all else being the same), I generally opt for the simpler business.