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More to the Story

Any investment strategy that is based upon buying well-run, high-quality companies and expecting the growth in earnings in these companies to carry prices higher can be dangerous, since the current price of the company may already reflect the quality of the management and the firm. If the current price is right (and the market is paying a premium for quality), the biggest danger is that the firm will lose its luster over time and that the premium paid will dissipate. If the market is exaggerating the value of quality management, this strategy can lead to poor returns even if the firm delivers its expected growth. It is only when markets underestimate the value of firm quality that this strategy stands a chance of making excess returns.

Failing the Expectations Game

A good company can be a bad investment if it is priced too high. The key to understanding this seeming contradiction is to recognize that, while investing, you are playing the expectations game. If investors expect a company to be superbly managed and price it accordingly, they will have to mark it down if the management happens to be only good (and not superb). By looking at the multiple of earnings that you are paying for a company relative to its peer group, you can measure the expectations that are being built into the price. It is prudent to avoid companies for which expectations have been set too high (multiples are high), even if the company is a good company. Figure 6.5 compares the average PE and price-to-book ratios for the sample of good companies constructed in the last section and the rest of the market.


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