Cheap Is Not Always Good And Stocks As Sweaters?

There are many investors who hold low P/E ratios as sacrosanct. To them, any stock with a high P/E ratio is off limits. While some stock certainly are overvalued, like Netflix at $300, or Green Mountain at $100, many stocks with high P/E ratios deserve them. Alexion Pharmaceuticals sports a P/E ratio of 80, while Pfizer, the king of the pharmaceutical industry, sports a P/E ratio of just under 16. Yet, over the past 5 years, Pfizer stock has not simply stagnated, it has dropped by over 22%, all while Alexion rose by over 466%. Investors who pounded the table saying Pfizer was cheap rode it all the way down to $20. While it is true that some stocks are simply too cheap, such as Apple or EMC, investors must always ask WHY a stock has a low P/E ratio. Often, there is a reason for that. Microsoft is cheap not because it is ignored by Wall Street, but because after close scrutiny, Wall Street did not like what it saw. There is so much more to investing than P/E ratios. That is merely one piece of the puzzle. And investors would do well to remember that "cheap" and "expensive" are simply matters of opinion. To truly gauge a company's suitability as an investment, one must always look beneath the surface and closely examine the company's future prospects.

Sentiment as a Contrarian Indicator

History has shown us that some of the most profitable investments are those made with a contrarian outlook. No one thought Apple would survive past 1997, but investors that ought in at that time doubled their money again and again. Buying financial stocks in March 2009 was a wonderful investment. Buffet's avoiding of dot com stocks was a great way to avoid losses. Sentiment is a great indicator of where a stock could go, but in the opposite direction. There's a rule in investing that says when retail investors pull huge sums of money out, that is the time to get in. Just as when retail investors are pouring money into the market, it is time to get out.

When sentiment in any one company turns extreme, we think it is time to go against the grain. A prime example of this is Netflix. For years, sentiment was extremely bullish on Netflix, and investors made huge sums of money on the stock. And if you got out in time, you made large sums of money too. But now, the sentiment surrounding Netflix is exactly the opposite. Everyone is predicting doom for the company. We see that as a contrarian buy signal, as long as you believe the company will survive. The bulls have had their success with Netflix. So have the bears. Now, we believe it is time for the bulls to be in the drivers seat once again.

Stocks as Sweaters

For all the complexities in the stock market, sometimes simple analogies can provide us with clarification. Investors would do well to think of stocks as sweaters. You wouldn't buy a sweater if it was too expensive right? If the quality matched the price, then perhaps you would. That is the case with companies such as Chipotle, or lululemon. They may be expensive, but these "sweaters" are worth it. Then, there are sweaters you want to buy, but they're simply too expensive. Companies like Alexion or salesforce may be good, but the "sweaters" are simply not worth the price. Then there are sweaters that have gotten too cheap to ignore. Companies like Akamai. Akamai used to be overpriced, but now it is simply undervalued, pricing in a doomsday scenario. However, some "sweaters" should be avoided, no matter how far in the clearance aisle they are in. Companies like RIM and Microsoft may be cheap, but they are cheap for a reason. You don't want to be seen wearing rags do you? Just as you don't want to be seen as getting ripped off buying some overpriced sweater. But, if its a luxurious sweater, than you will be the talk of the town. The lesson is, know your price, know the most that you are willing to pay for a stock, and know when to hand that sweater off to someone else.