Lately, over at Real Money, Paul Price has been talking about the trap that can be set by high-performing companies.
Investors naturally look for companies with strong business models, good performance and climbing stock prices. This is a signal of success, and they want to hold successful assets. The problem, Price says, is that this confuses what an investor is really looking for. As an investor, you want stocks that will go up. You make your money off the difference between the stock’s price when you buy and when you sell.
If you buy a stock that has already gone up, there’s not a lot of room left for that growth.
He looks at this problem with Costco:
“First ... the good news. Costco (COST) is a great company," Price wrote recently on Real Money. "It is fiscally strong, earnings are predictable and the shares established a new all-time record high of $560.78 intraday on Dec. 10, following a fine quarterly report."
In terms of overall business metrics, it doesn't get much better.
"The key EPS growth held steady at 11% annualized over the previous decade. It is expected to maintain similar, but slightly lower, growth rates across the board in the near future," Price noted.
"The old rule of thumb for investors was to limit purchases of stocks to those with price-to-earnings no higher than 1.5-times to 2.0-times their earnings growth rate. I'll give COST a nod toward the high end of that due to its outstanding track record."
However, "the theory would say to avoid the stock now as it commands about four-times its EPS growth rate right now. That suggests the shares are very, very pricey.”
That last line is particularly important. It isn’t just that high-priced stocks have little room left to grow. They also can represent stocks that have been overbought relative to the company’s position.
When a company does very well, that will bring in lots of investors. That can kick off a cycle of buying that pushes the stock’s price up, and then pushes it past where it really should be. That can lay the ground for even a strong company to lose value.
It’s something all investors should watch out for.