Value investing involves buying stocks at prices significantly below their intrinsic value, the difference being the Margin of Safety. Many investors mistake that concept with buying declining stocks and averaging down into them. What's even worse, they look for ridiculously low valuation multiples, strictly avoiding anything higher. This leads them into the worst stocks, automatically missing the best ones. Xerox (XRX) sold at a P/E of 100, before advancing more than 3000%, Google (GOOG) sold at a similar multiple at it's IPO, and we all know how that went. Remember, that many great stocks sell at high multiples initially, and maintain them for many years. If a stock grows it's earnings by 40% per year, the stock price has to advance by 40% for the P/E to stay constant! Consequently, what is a P/E? If I start a new business, am I concerned about the valuation multiple, or the growth of my company in the coming years? Will I not invest all my earnings into R&D, marketing and employee expenses, depressing earnings in the early years to fully profit from the future potential?
When I buy a stock at it's 52 week or all-time high, I do so because it is undervalued according to my analysis, in other words, the intrinsic value of the company is much greater than the price it's selling for. As Warren Buffett wisely said: "Growth is merely a part of the value equation". That means you can actually find undervalued stocks selling at their 52-week or all-time highs. I remember buying Celgene (CELG) at it's all-time high of 80, buying Apple (AAPL) at it's all-time high of 430, buying BOFI Holding (BOFI) at 28, buying Altisource Portfolio Solutions (ASPS) at 52, Ambarella (AMBA) at 14, SPS Commerce (SPSC) at 25, and the list goes on... What about huge past winners like Netflix (NFLX) or Green Mountain Coffee Roasters (GMCR), which made new highs exactly as the S&P500 bottomed in 2009? If you stop and think about it, all of the most profitable stocks in history had one thing in common: they kept rising in price, year after year, making new highs everytime on the way to the top. If I check the list of stocks making new highs, I know for sure there are huge future winners in there, I just need to know what traits to look for.
The main advantage of this approach is in cutting losses. When you buy a declining stock, and it keeps down, how do you keep your risk in check, how do you know you won't be stuck 5 years with a stock that isn't moving anywhere? When I purchase a stock at it's 52-week or all-time high, and the price starts to go down, I know for sure something is wrong, either my analysis or just the general market. In that case I get out of the trade and look for other good stocks to buy. If I keep my losses limited to 10-15% on a bad trade, but take profits after 50-100% and higher gains, then I can strike out pretty frequently and still have a great year. The key to profitable trading is to cut your losses short and let your winners run. If you take profits after 20%, you will never score a home run and your performance will suffer. Benjamin Graham himself stated, that the profits from the GEICO purchase (he put 25% of his portfolio into the stock) were greater than all of his other investments combined.
So does buying the best stocks making new highs work? Absolutely, provided you keep your risk in check and let your winners run, which are the basic tenets of profitable stock trading. Does buying declining stocks work? Yeah it may, but why not wait until they turn back up?