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There’s a Reason a Ferrari Cost More Than a Hyundai

June 23, 2014



If you want to buy a high-performance car such as a Ferrari, you’re going to pay a premium price. The same thing applies to high-performance stocks. The top 100 best-performing small- and mid-cap stocks of 1996 and 1997 had an average P/E of 40. Their P/Es grew further to an average of 87 and a median of 65. Relatively speaking, their initially “expensive” P/Es turned out to be extremely cheap. These top stocks averaged a gain of 421 percent from buy point to peak. The P/E of the S&P 500 ranged from 18 to 20 during that period.

 

Value investors often shy away from stocks with high price/earnings multiples. They won’t touch a stock whose P/E is much higher than, say, that of the S&P 500 index. Savvy growth players know that you often have to pay more for the best goods in the market.

 

Consider CKE Restaurants, which sported a relatively high P/E just before the stock price took off. CKE Restaurants emerged into new high ground in extremely fast trading on October 13, 1995. Right before its breakout, the stock had a P/E of 55, or 2.9 times the S&P’s P/E of 18.9.

 

The company had scored triple-digit profit growth in the two most recent quarters. Analysts saw the operator of Carl’s Jr. burger shops increasing profit by a whopping 700 percent from year-ago levels in the upcoming quarter. The stock climbed for 103 weeks. It finally peaked near $41 in October 1997 for a 412 percent gain.

 

 

High Growth Baffles the Analysts

 

Wall Street has little idea what P/E ratio to put on companies growing at huge rates. It’s extremely difficult, if not impossible, to predict how long a growth phase will last and what level of deceleration will occur over a particular time frame when one is dealing with a dynamic new leader or new industry.

 

Many superperformance stocks tend to move to extreme valuations and leave analysts in awe as their prices continue to climb into the stratosphere in spite of what appears to be a ridiculous valuation. Missing out on these great companies is due to misunderstanding the way Wall Street works and therefore concentrating on the wrong price drivers.

 

In June 1997, I bought shares of Yahoo! when the stock was trading at 938 times earnings. Talk about a high P/E! Every institutional investor I mentioned the stock to said, “No way—Ya-WHO?”

 

The company was virtually unknown at the time, but Yahoo! was leading a new technological revolution: the Internet. The potential for what was then a new industry was widely misunderstood. Yahoo! shares advanced an amazing 7,800 percent in just 29 months, and the P/E expanded to more than 1,700 times earnings. Even if you got only a piece of that advance, you could have made a boatload.

 

Excerpt from Trade Like A Stock Market Wizard by Mark Minervini (McGraw Hill Publishing –2012)



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