Why Expensive Shares Can Be Cheap

In investing, one of the most common axioms would be to ‘buy low, sell high’. The premise is simple – you buy a share that’s cheap, and you sell it when it’s expensive. And for most investors, the idea of a cheap share is probably one that carries a low valuation, such as a share that has a low Price-Earnings multiple.

Buying cheap shares can work….

Studies have shown that buying shares based on low valuations have performed well historically in the US and other parts of the world.

In Singapore, Teh Hooi Ling, Executive Money Editor of The Business Times has also done research on the returns of local stocks with low valuations. She found that stocks that have either a low PE, low Price-to-Sales or low Price-to-Book ratio have done much better than the Straits Times Index (SGX: ^STI) over long stretches of time.

So, the argument on buying shares based on a cheap valuation certainly carries some merit. But on the other hand, are shares carrying high valuations really ‘expensive’?

For instance, Keppel Telecommunications & Transportation collapsed partly because of unreasonably rosy expectations placed on it in the form of a high PE multiple, so there are precedents. But, will all shares with high valuations necessarily end up as sob-stories for investors?

But can buying expensive shares work?

I’ve recently shared five shares that went on to at least double in price even if investors had bought them at the Straits Times Index’s (SGX: ^STI) pre-Great-Financial-Crisis peak of 3,876 points on 11 Oct 2007 and held them till 2 July 2013.

Those five shares’ returns were remarkable, given the fact that on 2 July 2013, the STI was still 18% below the pre-Crisis peak. The key was that these companies had managed to grow their earnings through the GFC, with profits being higher in July 2013 compared to 2006.

The profit growth made the businesses of those five companies a lot more valuable.

But, what is interesting here was the valuation – based on the PE ratio – which those shares had on 11 Oct 2007.

11-Oct-07 18-Jul-13  
Price TTM PE* Price TTM PE* Price Change
Super Group (SGX: S10) S$0.88 15.5 S$4.71 31.5 435%
Vicom (SGX: V01) S$1.78 11.2 S$4.71 15.4 165%
Dairy Farm Holdings
(SGX:   D01)
US$5.10 30.4 US$11.96 35.8 135%
Raffles Medical Group (SGX:   R01) S$1.51 24.2 S$3.12 30.0 106%
Jardine Cycle & Carriage (SGX:   C07) S$20.20 16.1 S$40.45 12.2 100%
* TTM PE = Trailing-12-months’   Price-Earnings Ratio

So, buying expensive shares can work

Turns out, among the five winning shares, there were two – Dairy Farm and RMG – with high PE ratios. It is important to stress here that those two shares had high PE ratios at a market peak, so that’s a little akin to adding oil to fire. Yet, investors in Dairy Farm and RMG had turned out fine.

It’s true that the shares with the lower PE ratios, such as Vicom and Super Group, did even better as their earnings-multiple expanded along with earnings growth. This can sometimes happen when investors get more excited about the prospects for a share and bid up its price.

But, the point is that not every share that carries a high valuation, such as a high PE multiple, is automatically a losing proposition.

Besides valuations, the future corporate performance of businesses also plays a huge role in determining future returns, as exemplified by Dairy Farm and RMG’s total growth in profits of 213% and 374% respectively from 2006 to July 2013.

The outsized profit growth of those two shares suggests that the high PE ratios that investors were paying weren’t exactly pipe-dreams of hope.

Foolish Bottom Line

While cheap shares are undoubtedly a good place to start hunting for bargains (though investors have to beware of value-traps), shares with expensive-looking valuations do not necessarily make for poor investments either. Automatically dismissing such shares without further research might mean losing out on possible bargains.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing owns shares in Super Group.