2021 saw the markets draw a consensus view that it is alright to buy quality stocks at any price. This view led to a PE multiple expansion in small and mid-sized companies. The PE multiples of small companies never expanded as much as it happened in 2021. This trend was also attributable to the narrow investment universe of institutional investors and the intense competition to find quality businesses among all market participants. So, we had everybody chasing a smaller subset of stocks.
Naturally, irrationality was seeded in this hunt for good ideas. That irrationality led to the PE expansion we saw in 2021. Once PE expanded, people interpreted it as a validation of business fundamentals. But it was more a reflection of investor competition and idea scarcity than validation.
2022 will see a reversal and not a repeat of 2021. In 2022 investors must wear the hat of caution and be more discerning in what they pay for a quality business. Paying less to buy a better-quality business is the only way investors can assure good returns in the long run. We simply cannot afford to overpay as we did in 2021.
Overpaying leads to losses or long time corrections. Investors need to pay the right value to buy quality stocks. Ensuring that we buy at the right valuation is going to be the biggest challenge for investors in 2022. While the number of good ideas may not increase at the rate we want them to, we would still need to find new ideas.
It is important that investors identify the businesses they want to own, and wait to buy them at a reasonable valuation. Buying quality at a reasonable price should be the top priority of every investor in 2022.
2021 was probably a glorious aberration that cannot sustain. Needless to say, doing what is sustainable is the most important thing for long term investment success.