I used to be obsessed by the price/earnings (p/e) ratio. If a company had a low p/e ratio, I was immediately tempted to buy.
But as I became more experienced, I realised that some shares were cheap for a reason – they were companies that would always struggle.
And I also came to realise that shares which seem expensive can sometimes make the best investments.
So today, I’m going to look at when it makes sense to buy ‘expensive’ shares and also highlight a couple of companies that could prove to be decent investments right now.
Follow Terry Smith – pick companies that have already ‘won’
This feature was inspired by a Telegraph article by City veteran, Terry Smith.
Smith first became well known for writing Accounting for Growth in the early 90s, a book that exposed various ‘creative accounting’ tricks which were common at the time.
More recently, he’s been managing the Fundsmith fund which follows a concentrated strategy of investing in relatively few stocks – around 25. The fund has been a top performer over the last three years.
Smith’s investing style is to focus on shares that have already ‘won’; in other words they have strong market positions. He also looks for companies that deliver high returns on capital employed and convert most of their profits into cash flow.
In the article, Smith cites Coca Cola (NYSE: KO) and Colgate Palmolive (NYSE: CL) as good examples of what he looks for. Back in 1979 both companies were trading on price/earnings ratios of ten, roughly in line with the market as a whole.
Since then they’ve outperformed the market by about 5% a year in terms of total return. (Total return comprises dividend payments and share price appreciation.)
That may not seem like a huge difference, but thanks to compounding, that annual outperformance of 5% works out as a total outperformance of 320% over the following 30 years.
To put it another way, if Coca Cola and Colgate Palmolive had actually been trading on a multiple of 40 times earnings in 1979, you would still have matched the market over the next 30 years.
This strong performance is mainly down to the fact that both companies have strong brands which means they have pricing power. They’ve also been able to grow profits and sales without having to invest enormous amounts of capital.
Easily compare UK shares by sector or index using our free performance tool.
Which companies will be the winners over the next 30 years?
Of course, looking at shares that have done well since 1979 is all very well, but we want to find shares that are going to do well over the next 30 years. Even if they seem to be rather expensive at first glance
One possibility is the drinks giant, Diageo (LSE: DGE). It’s currently trading on a rather high p/e of 19, but don’t let that high rating put you off.
For starters, the company pays a reasonable dividend – about 2.5% – but more importantly it has a wide range of strong brands including Guinness and Johnnie Walker. That means that the company has already ‘won’ the race to be a market leader in drinks.
What’s more, the company has produced a return on equity of at least 32% every year since 2004. That means it shouldn’t be a problem for Diageo to carry on growing profits and the dividend.
I remember looking at Diageo as a possible investment back in 2006, but I rejected it because I thought the p/e was too high at 19. The share price was around 950p back then, so I’ve missed out on dividend payments worth £2.91 per share as well as a £10 rise in the share price.
I corrected my mistake last year and bought some, and I’m confident that I’m going to get a decent return over the next decade, largely thanks to the power of the brands.
I also really like Coca Cola, which is another share I own. Just like Diageo, it’s trading on a p/e of 19, but I think it will continue to perform well thanks to the strength of the brand as well as opportunities for growth in emerging markets.
It also has a great history of delivering high returns on equity – at least 27% every year for the last decade. For most of that time, Coca Cola has looked ‘expensive’ on several measures, but you would have been fine if you had bought. You’d have received a decent dividend as well as nice rises in the share price.
So for me, the lesson is clear. Highly priced shares can deliver good returns as long as you’re selective. Look for strong market positions and decent returns on equity and capital.
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