By many measures, investors may still view the markets as being cheap. Hundreds of solid businesses are trading at multi-year lows. Companies sporting single digit price to earning ratios still abound.
Price Paid Determines Value Received
Still I would be careful in mistaking low prices and low "valuations" with value. Mistaking a once expensive stock of a good company that has experienced a substantial decline in share price as a bargain can often feel like a catching a falling knife. These "falling knives" can be dangerous, if you catch them the wrong way.
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The dry bulk shipping sector offers an instructive example. Consider DryShips (Nasdaq:DRYS) which today sits around $6. Two years ago, shares sat at $120; a year ago shares sat at $70. In 2007, DRYS earned over $13 a share. Investors who saw this stock at $30 and thought it was cheap were cut badly at $20, $10 and where the shares lag now.
The downfall for investors in this case was paying far too much attention to price and very little to the actual intrinsic value of the business. Ironically, now with shares at $6, the company is perceived as a riskier investment. (For more, see The Dead Cat Bounce: A Bear In Bull's Clothing?)
Focus on the Business; Not the Stock
One of the most appealing restaurants is burrito chain Chipotle (NYSE:CMG). It sells excellent fresh gourmet burritos at fast food prices. The company is growing strongly. When you consider that McDonalds (NYSE:MCD) - of which Chipotle used to be a part of - has nearly 32,000 locations worldwide and Chipotle has around 900, the future looks very promising indeed.
Unfortunately, Mr. Market loves Chipotle as well. At 30-times earnings, the shares are priced for perfection. As much as I would love to own a piece of Chipotle, I leave myself no secure margin of safety at the current valuation. At current prices, you're banking on flawless execution. While Chipotle management is held in high regards, it is not flawless.
But Chipotle is a quality company, so while it seems worthwhile to buy it at 10-times earnings, the company would need to have a serious setback to bring shares within that valuation. Instead, appreciating the long-term value of this business, investors should take a closer look if shares within a 15-18 earnings multiple are found.
Just remember Google (Nasdaq:GOOG) a few years ago, when investors priced the company for perfection. Despite the phenomenal growth, investors paid $600-700 without any regard to the company's valuation. Google's a fine company, but at those prices it wasn't a fine investment.
The Bottom Line
Investing is simple to understand, but not easy to execute. The key is to exercise discipline and understand what you are paying for. If not, you could find yourself wondering why such a 'great business' lead to lousy results.
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