Shares in quality companies often trade at a premium. Investors, myself included, often bulk at the valuation these best in breed businesses trade at and often forgo buying shares in them as a result. But if history has taught us anything, it is that quality shares are often worth paying up for. Even at the higher valuation ratings, these companies consistently beat the markets.
Professor Jeremy Siegel, in his book the The Nifty-Fifty Revisited showed retrospectively that a high quality, well-branded company such as Coca-Cola, with a steady earnings growth record could in fact support extremely high multiples – even higher than Coke?s then PE of 46x. A year or two after the Nifty Fifty stocks had hit their peak valuations this multiple was criticised as having been a severe overvaluation, perhaps with some justification for those with shorter term time horizons. However subsequent price gains demonstrated the opposite as long term holders of Coke?s shares, despite some poor performance from 1972-1985, actually compounded returns at 17.2% per annum total return over the 25 years from 1972-1997. Siegel showed that for Coke to have performed no better than in line with the market between 1972 and 1997 it could in fact have started on a PE of 92x.
The best companies beat the earnings consistently. Investing is about looking forward and buying into companies that consistently beat earnings can pay off handsomely.
Take Company X. It has a revenue of £100m and it is expected to grow its revenue by 25% for 10 years.
Over that period, the revenue will shoot from £100m to £931m. If the valuation doesn’t change, you will have a 9 bagger over that decade.
But suppose that this company beats the expectations by 7% each time, which the best companies certainly are capable of (and more).
Instead of £931.3m, the company’s revenue now comes in at £1.6 billion and with the same valuation, you have a 16 bagger. Even if the valuation rating is cut in half, you have an 8 bagger. That’s the power of compounding earnings beats.
It’s one of the elements that are underestimated by so many investors. Premium prices are often warranted for companies that have proven that they can beat the estimates again and again. But many individual simply look at the valuation on any given day and feel it is too expensive. The truth is, investors should be looking a few years out and see what the business will accomplish then.
In 90% of the cases, the market can value better than you. Be humble and buy quality.