When most people scan for new shares to buy, chances are, they include some valuation metric like the price-earnings ratio or P/E.
As we know, the P/E puts a company's share price, P, in a ratio with earnings, E. We are taught a lower P/E is preferred to a higher P/E.
A herd mentality
The general consensus among investors is the lower P/E is better for us because we get more earnings (or profits) for every dollar we invest.
However, what many investors fail to consider is the quality of those earnings. We often say 'we'd pay up for growth', meaning we'd consider owning a high P/E share. However, in reality, this is uncomfortable because it goes against what we are taught (i.e. the herd).
Overvalued or overlooked?
For some investors, overlooking a high P/E is — arguably — the most appropriate course of action. For example, a retiree shouldn't own an entire portfolio of high P/E shares with no dividends (or so we're taught).
For other investors, challenging conventional wisdom by buying only 'overvalued' shares has proven to be a terrific investment strategy.
The Motley Fool's Co-Founder, David Gardner, uses such an approach. His 'Rule Breakers' investment strategy has delivered some spectacular returns (as well as some not so spectacular returns) by focusing on shares which challenge conventional valuation techniques.
He summed up the process perfectly in the following quote, taken from this article written in 2006:
"If a company is growing its earnings and, as a result, has an increasing valuation, there will be someone somewhere arguing that the company is overvalued. This is valuable, because it keeps people out of a stock; later on, as the company proves out its position as a profitable, even dominant, leader, then the sceptics finally buy — which is what can give you serious appreciation as an early investor in these growth stocks!"
That's one rule David uses to find great companies early in their lifecycle.
Home Grown Rule Breakers
Using the same strategy on the ASX, many Australian investors would have overlooked CSL Limited (ASX: CSL) in its early years because it appeared overvalued. CSL shares are up 2,418% in 15 years. The same can be said of Cochlear Limited (ASX: COH), which is up 1,000%.
Both sets of returns exclude dividends paid.
Is this ASX share overlooked?
Perhaps it's time to ask ourselves: Which shares have recently been labelled 'overvalued'?
Bellamy's Australia Ltd (ASX: BAL) springs to mind. It is a small company operating in a very big market. Its shares are up 646% in two years. Bellamy's shares trade at more than three times the S&P/ASX 200 (Index: ^AXJO) (ASX: XJO) average P/E ratio of 16x.
Foolish takeaway
Don't for a second believe there isn't a method to the madness of buying 'overvalued' shares.
Overvalued shares can be expensive for many good reasons. For example, companies that can forge a competitive advantage and earn excess returns from their investments will soon make up the valuation gap on their cheaper lower 'quality' peers.
Not every investment we make will be a winner, either. But it's important we remind ourselves that we cannot lose more than 100% of our investment — yet we can make much more — and as David wrote: "You can't score if you don't shoot".
