To make the most money over the long run, you want to buy the best stocks you can find. But if you pay too much for stocks with big growth potential, they may not benefit you over time -- even if the company does in fact grow substantially.
Investors have seen this same development countless times: previously unknown stocks burst onto the scene with amazing growth, and their shares rocket in response as investors jump on board. Those hypergrowth phases can last for months or even years, bringing high returns to shareholders -- until growth starts to stall, spooking momentum-watchers and often bringing a significant downturn to the stock.
Looking at the emerging-market craze
For instance, emerging-market stocks have been on a tear recently. Even though the rally has sent stocks around the world higher, companies based in emerging-market countries have seen some of the most extensive gains. Here's a quick sample:
| Stock | Country | 2009 YTD Return |
|---|---|---|
| Vale (NYSE: VALE) | Brazil | 64.2% |
| Tata Motors (NYSE: TTM) | India | 135.7% |
| Mechel OAO (NYSE: MTL) | Russia | 183.3% |
| Baidu (Nasdaq: BIDU) | China | 173.3% |
Source: Yahoo! Finance.
Those who are familiar with the opportunities in these emerging markets won't be surprised by the fact that these companies are still growing. After all, some emerging-market countries are still seeing their economies grow, albeit at a slower pace than in recent years.
But even though investors have been willing to pay a premium for the growth prospects of emerging-market stocks, should you really pay triple what you would have just seven months ago for a stock? While growth is an attractive attribute for a stock, growth at any price can prove hazardous to your portfolio.
Are you getting value?
Over the weekend, the Wall Street Journal cited figures from the London Business School that shined some light on the question of whether investors pay too much for stocks with great growth prospects. According to the research, stock markets in the fastest-growing economies earned a return of about 6% per year. However, those with the slowest growth actually put in much better returns, averaging 12% annually. That comes from the higher prices that investors pay for the hottest markets.
You'll see the same phenomenon with individual companies as well. Often, stocks will be priced for perfection, and anything short of that could send share prices tumbling. Consider these stocks:
| Stock | Current P/E | Forward P/E | 5-Year Growth Est. |
|---|---|---|---|
| Rackspace Hosting | 74.4 | 38.8 | 23% |
| Amazon.com (Nasdaq: AMZN) | 55.5 | 39.0 | 22% |
| Sears Holdings (Nasdaq: SHLD) | 61.8 | 35.5 | 10% |
Source: Yahoo! Finance.
If these companies continue to produce strong growth -- and it's certainly possible that they will -- then today's lofty valuations may well be completely justified. But even the slightest dropoff from their expected growth trajectory could bring investors less stellar returns, despite the fact that the companies may eventually grow to become some of the largest in their respective industries.
Get growth at the right price
Of course, the perfect combination to look for is a company with terrific growth prospects whose shares trade at attractive multiples. They're a lot harder to find, but considering how far the market has fallen, they're not impossible to discover:
| Stock | Current P/E | Forward P/E | 5-Year Growth Est. |
|---|---|---|---|
| Aeropostale | 15.1 | 11.7 | 14% |
| Humana (NYSE: HUM) | 6.8 | 5.7 | 12% |
| Mirant | 1.9 | 11.3 | 26% |
Source: Yahoo! Finance.
Of course, for these to be true bargains, you have to trust analyst projections of earnings -- something you should always take with a grain of salt. But with these stocks at least trading at more modest valuations, you have a larger margin of safety against any inevitable shortfalls that turn up in those earnings estimates.
Doing the right thing
The takeaway from all this is to think twice when you find a great stock that commands a premium price. If the company continues its winning ways well into the future, then you can still reap rich rewards. But sometimes, you'll find that the stock's best returns are behind it -- and you'll be left holding the bag.
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