Why investors buy stocks at record prices

And yet here we are, with the S&P 500 near or at all-time highs. The Australian market is also simmering near its record struck just a few weeks ago. So what’s going on? Should you be buying?

Buying at all-time highs means paying a price no one has ever paid before, but on the flipside, history shows that stocks do poorly in anticipation of a war or armed conflict, yet tend to rally once the fighting begins. History also suggests that since 1950, the S&P 500 has fallen by 10 per cent or more just 9 per cent of the time after registering an all-time high.

Could it be that investors see value even among the frightening headlines? And if so, where?

It’s undeniable that the market valuation of the S&P 500 remains at one of the highest levels in 45 years. The last time the S&P 500’s price to earnings (P/E) ratio was at this level was just before Covid hit. In Australia, the P/E for the S&P/ASX 200 sits at 19.24 times earnings, just a few points off the all-time high of 22.7 time historical earnings in September last year. And for context, the most recent low was 12.5 times earnings in June 2022.

Importantly, high P/E ratios are not an indicator of an imminent crash. Theoretically, market P/Es can remain high forever because they merely reflect investors’ willingness to pay those multiples.

What makes investors want to pay less? It’s usually fear. But it’s usually a fear of something investors hadn’t prepared for. A war preceded by the “threat of war” is a war that investors have had time to prepare for. Investors only tend to run for the hills when fear is inspired by something unexpected.

The solution is to invest in quality companies with solid growth prospects. That suggestion is based simply on basic arithmetic. Buy and sell shares at the same P/E ratio, and your internal rate of return will equal the company’s earnings per share growth rate.

For example, acquire the shares of a business whose earnings per share is growing at 20 per cent per annum, on a P/E multiple of 25 times earnings and sell them on the same multiple of 25 times a few years later. The internal rate of return will equal the EPS growth rate of 20 per cent. You will make 20 per cent per annum.

P/E ratios can swing wildly. At the end of 2022, the S&P 500’s one-year forward P/E was 16 times earnings. Today, it is 21.2 times. In other words, investors in the US market today are willing to pay 32 per cent more for the same dollar of earnings than they were willing to pay in 2022.

As Ben Graham and Warren Buffett observed, in the short run, the market is a voting machine, and no IQ test is required to vote. Consequently, shifts in sentiment are frequent and can be extreme due to emotion.

Knowing this, it becomes imperative to identify businesses that your due diligence leads you to conclude will grow their earnings rapidly.

Understanding what a business can achieve, and how and when it will get there, requires consideration of its competitive position and the competitive landscape today, as well as how those elements will evolve.

Sharemarket investing is first about identifying wonderful businesses, then about purchasing those businesses at prices likely to produce an above-average rate of return. Growth naturally becomes a component of determining value, and therefore, growth and value investing are two sides of the same coin.

Nvidia’s almighty run

Let’s now turn to one of the companies leading the market higher.

In August 2023, Nvidia was trading at a P/E of 245 times historical earnings, while the market was trading at a P/E of 24. Trading 10 times higher than the price-to-earnings ratio of the S&P 500, it could hardly be described as a value stock. But over the next two years Nvidia rallied more than 200 per cent, while the S&P 500 produced 32 per cent.

The reason? Nvidia’s revenue and profits soared. In mid-2023, Nvidia’s net income for the previous 12 months was $US10bn. A year later, it was $US53bn. In the most recent quarter, the company earned $US76bn.

The surge in profits means that the company’s shares are now trading on a P/E of less than 50 times. Other companies, including Meta, Amazon, Google and Microsoft, have all seen revenue and profit soar.

The question for equity investors isn’t whether Donald Trump, bond yields or the Middle East could disrupt markets. It should be whether we might miss great opportunities because we don’t believe in the sustainability of the growth rates of the next batch of global companies creating the tools that individuals and companies use to create new business models and new revenue streams.

Roger Montgomery is founder and CIO at Montgomery Investment Management.

This article first appeared in The Australian as Is it worth buying expensive stocks?