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The Perils of High-P/E Stocks

The Higher They Are, the Harder They Fall

Financial journalist Jason Zweig has a well-known interest in behavioral finance, the study of how investors’ minds work — sometimes against their best interests. In his latest book, Your Money & Your Brain, he deals with the “story stock,” the must-have equity of the moment that only investors with the strongest convictions can avoid.

Think Krispy Kreme, which went public in 2000 after the market crash and climbed from $23 to over $100 a share. Yes, a doughnut company had a price-earnings ratio above 80. A doughnut company.
Krispy Kreme is losing money now and trades for just over $3 a share. But at the time it had exactly what investors craved — a simple business model, a good (some would say addictive) product, room to grow from a regional to a national chain and the attention of both the media and Wall Street analysts.
These are the types of stocks that play well in the human mind, Zweig says. Investors are naturally risk-averse and wary of potential surprises. High-profile companies that get a lot of attention and are mentioned on the nightly news and on financial websites seem less likely to surprise us. They seem safer.
There’s also a perceived safety in numbers. No matter how often we’re told that 50,000 people can indeed be wrong, we’re afraid to be seen as out of step with our neighbors. To be wrong while acting as part of a group is understandable. To be wrong on your own is just plain embarrassing.
The result of this, writes Zweig, is that a stock might do well for the wrong reasons in the short run. But eventually the fundamentals will catch up with it.
Remember, it’s negative surprises that send most investors fleeing, and when they seek safety, they wind up buying stocks that today are telling happy stories of high growth. This means the effects of any negative news about these stocks are amplified. And when the story turns ugly, it turns in a hurry.
Zweig calculates that if a growth company misses its earnings forecast by as little as 3 cents a share, its stock will drop two to three times faster compared with a value stock reporting the same bad news. When a high-growth company misses earnings, it can cause a crisis of confidence. Many analysts, for example, believe there’s no such thing as one bad quarter; when a high-growth company stumbles, investors fear more bad news is on the way.
But over time, less-popular, lower-P/E stocks do outperform. In his updated edition of Stocks for the Long Run, Wharton professor Jeremy Siegel measured the performances of low-P/E and high-P/E stock portfolios between 1957 and the end of 2006. The portfolio with $1,000 invested in stocks with the lowest P/E ratios was worth $700,000, for a 14.3 percent annual return. The portfolio with $1,000 invested in the highest-P/E stocks was worth $65,000, for a return of 8.9 percent a year. 
What’s more, during the first 10 years the high- and low-P/E portfolios traded places a few times, depending on market conditions. But once the experiment passed the decade mark, returns on the low-P/E stocks were always higher.
Of course, it’s important to put P/Es in context. You should compare a stock’s P/E with that of its peers and to the rest of the market and remember that some stocks deserve a higher valuation.
Growth and value also go in and out of favor; cycles usually last five years to seven years. But investors with time on their side would do well to be wary of trendy story stocks because they can turn in an instant.

Michael Maiello, who wrote "Fly With The Fundamentals" for the January 2006 issue, is author of Buy the Rumor, Sellthe Fact (McGraw-Hill, 2004).

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