One thing that does not bother me is the poor total performance on an annual basis of many blue-chip stocks dating back to the 1999-2001 period. When large-cap companies like Coca-Cola (NYSE:KO) and Johnson & Johnson (NYSE:JNJ) traded at prices above 30x earnings, it can be difficult to build wealth when you're starting from an initial earnings yield of 3-4%. When I look back upon the past fifteen or so years in the stock market history, I become more convinced than one of Benjamin Graham's rudimentary guidelines about value: either regard the purchase of a stock with a P/E ratio above 20 as a speculative investment, or decline the purchase of securities with a P/E above 20 altogether. The general premise of that statement is that when an investor starts with a base earnings yield below 5%, he is acting without a margin of safety because he needs above average growth to bail out the price paid for the investment.
The general rule of not paying more than 20x earnings for a stock is useful for an investor with a defensive orientation. The best reason not to follow this rule is that there can be lucrative opportunities that would get ruled by a strict adherence to this guideline. After all, if you paid over 40x earnings for the Starbucks (NASDAQ:SBUX) initial price offering in 1992, you could have accumulated over $4.15 million on a $50,000 investment, assuming optimal tax strategy. The Graham rule forces you to miss those types of life-changing opportunities. Nevertheless, the appeal of never paying more than 20x earnings for an investment is that it can eliminate a lot of the folly that can overtake the marketplace. You don't get hurt by missing out on the Starbucks investment, but you do get hurt by participating in the dotcom boom by paying 100x earnings for a rising tech company with mediocre sales. If you get in the habit of not paying more than 20x earnings for any of your investments, you can create a natural margin of safety that will greatly increase the likelihood that phrases like "lost decade" and "bubble bust" never become a part of your vocabulary.
If you're someone who easily gets bothered by investment decisions of omission, then Graham's rule of never paying more than 20x earnings may hold limited appeal to you. There's always some investment you can point to that produced successful returns from a starting threshold of over 20x earnings. If you're the type of investor that easily feels like you're "missing out" on something, then you may not take Graham's guideline seriously. But if mitigating investment decisions of commission is one of your primary goals, then the Graham rule may be a godsend because it limits the likelihood that you will be a victim of P/E compression (the phenomenon that occurs when earnings rise but the stock price does not rise commensurately because investors want less for each $1 of earnings).
The most appealing thing to me about incorporating the "never pay above 20x earnings for a stock" rule is that it just oozes with common sense. I love the business models of Hershey Foods (NYSE:HSY) and Brown-Forman (NYSE:BF.B). Both companies are simple to understand. It's easy to understand chocolate and alcohol. The businesses have little risk of being disrupted by a major technological change. Their earnings are predictable. To cut to the chase, both companies exhibit the kind of qualities that seem like dream long-term holdings. But identifying an excellent business is only half of the process. The problem is that Hershey currently trades at 25x earnings and Brown-Forman currently trades at 24x earnings. Graham wouldn't touch these stocks. The margin of safety in the high quality of business is not enough. There must be a margin of safety in the purchase price as well. Declining to purchase either of these stocks based on Graham's 20x earnings rule applies the common-sense practice that you don't want to rely on above-average growth to come out okay.
A steadfast adherence to Graham's admonition not to pay over 20x earnings for a stock (or at the very least, to recognize such an investment as speculative) can go a long way towards ensuring that you will never participate in a stock market bubble. Personally, I seek out margins of safety in two forms: I like to purchase high-quality businesses, and I like to buy them at reasonable prices at better. If you keep Graham's rule of never paying more than 20x earnings in your back pocket, then you have taken a great first step in creating an automatic safeguard that may protect you from the folly of overpaying for an investment.
Disclosure: I am long JNJ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.