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Investing’s golden rule is simple: buy cheap!

Every investment guru has said this — sometimes in books, sometimes on Twitter, sometimes while sipping Cherry Coke.

• Benjamin Graham: “The margin of safety is achieved by having the foresight to purchase securities at a significant discount to their intrinsic value.”
• Warren Buffet: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
• Seth Klarman: “Buying at a discount protects you from the downside and allows for upside optionality.”
• Howard Marks: “When you buy at a discount, you have a cushion that protects you if things go wrong.”
• Peter Lynch: “You have to know what you own, and why you own it. And you have to own it at a reasonable price.”
• Charlie Munger: “The number one idea is to view a stock as a piece of a business and to buy at a reasonable price.”

In other words: buy cheap.

Easy, right? Then why do we keep forgetting this the moment the market turns green?

I admit – judging valuations is not easy, given the complexity and confluence of various factors such as future growth, profitability, market sentiment and an array of unforeseen events in the future. Most of the time, we tend to make comparisons with the past to determine what cheap really means.

However, our idea of ‘cheap’ quietly drifts higher every bull market — just like Securities Transaction Tax. Being only human, we look at the recent past and extrapolate (also known as the “recency” effect). In effect, during a bull phase, we tend to shift the goalposts, forgetting that there were ever any bear phases. And such is the strength of the herd (or FOMO), that even experienced investors and fund managers are not immune. Nobody wants to be the grumpy uncle sitting on cash while his nephews and nieces are raking it in on defence stocks.

Consider the case of Hindustan Unilever (HUL). Several brokerage reports currently have buy calls based on a forward P/E of > 50 in FY27 or FY28. You might see statements like, “Current valuations at 56 times earnings are at a discount to 5 year average P/Es of 61, making the stock cheap from a historical perspective”.

However, the average P/E for HUL was around 30 between 2007 and 2012!

Interestingly, the stock touched a P/E of nearly 80 in September 2021, and the current share price is lower than it was then. Undoubtedly, it is a great company, but is it cheap?

And there are plenty of such examples – I picked HUL since it is a mature stock, where growth is unlikely to be dramatic. Also, it is not one of today’s “meme” stocks in the defence or infra sectors.

I ran some quick numbers on screener. Today, 47% of companies with a market cap of ₹5,000+ crores are valued at a P/E of > 40, and 36% have P/Es of over 50. These include most of the “quality” companies, many new-age, high-growth businesses and even traditional, cyclical businesses. Conversely, less than 10% of this universe is valued at below 15 P/E.

Do these valuations really provide any “margin of safety”?

Or have we got so used to high multiples that 50x seems like a clearance sale?

I know the argument is simplistic, and one might argue that high-growth stocks (of which there are several in the list) deserve their elevated valuations, given high double-digit growth. But how many of these can deliver earnings growth of 25-30% over an extended period?

Such outperformance requires exceptional management, significant competitive advantage, sustained tailwinds and superior execution. Valuations suggest that nothing can go wrong. No threats from wars, supply chain woes, no regulators in a bad mood, and no 3 a.m. tweets from Donald Trump.

Sure, a few companies will actually achieve this. But the vast majority won’t. And their stock prices will either decline or face a time correction.

Most investors are wired to buy. We feel nervous holding too much cash. And most of the time, we believe we are immune to making rudimentary mistakes. We don’t like hearing that returns going forward might be weaker than the recent past. And most of all, we suffer from super-FOMO.

I know that markets can get severely more overvalued before they correct.  But even if we do have a rally from here on, you will likely make more money on undervalued stocks (if you can find them), than on a bunch of super-expensive companies – no matter how great they are! Of course, some companies will still be cheap, even by objective measures. However, these stocks are few, far between and increasingly difficult to spot. If you can find any, go ahead and buy – the valuation will provide the margin of safety. However, for the most part, today’s valuations make life extremely difficult for a value investor.