“I will buy this stock- the price has risen sharply recently.” I hear this sentence from friends and strangers almost every week. The other most popular is “I will buy stock of Zoom/Netflix/Pfizer/Apple/or any other popular company, because everybody is buying their product.” You might feel a little tricked, because of the slightly “click-baity” title, but I did it on purpose. Why?
I am confident that many of you got a little rush thinking “ooo, there is some rising stock, I can’t wait to get on that train and make some dollars $$$”. And I am also 100% confident you wouldn’t get any rush if I wrote “I will buy this stock, because the company is profitable, has a lot of free cash flow, has no debt and is available for a good price (definition of value investing) ”.
It for sure sounds more boring, but I would like to explain, why buying stocks only because of rising prices or because everybody is buying the company’s product is not a good idea. The key word here is “just”. There is nothing wrong with buying stocks when the prices are rising or when the company’s product is successful and sought after- but you should be aware of other underlying conditions.
The rationale of people who buy these rising, popular stocks is something in the sense “if the prices are rising and people are buying the stocks so much, there must be something about it, therefore its a good company and the price will continue to rise”. And fair enough- sometimes it is the case that they truly are great investments. But you cannot stop here and rely solely on this logic. You have to go further and investigate the stock closer to understand its business, its future outlook and just make sure that the company will continue growing and being profitable.
Why it fails
To rely on the logic of rising prices as the only indicator of success of the investment, you would have to assume that the markets are perfect, i.e. all the information is included in the price and all investors are rational. In simple words, it would mean that the rising prices indicate great, valuable company with huge earnings and vice versa, falling prices would mean a low quality company with no earnings. By this logic, it would also mean if the prices are rising extremely sharply, you can expect stellar results from the company- super high earnings and your home run investment.
Well, we know from history that just isn’t the case- dot.com bubble is a quite significant and a recent example of markets and investors not being efficient nor rational. People were buying internet stocks, simply because they were internet stocks and their prices were rising sharply as we described. But what was the underlying reality of these companies? There were some good ones for sure, as Cisco or Oracle, but most of them were just funky start-ups with no real business model, no revenues and no earnings. Nonetheless, their stocks were reaching extreme heights, based again on only previous rising prices and stock returns.
You just cannot forget the basic principle of stock investing– providing companies with capital, so they can use that capital to generate earnings, which they will return to you at some point. If the companies are in huge losses, generate no money or just have terrible business model in general, they just won’t return the capital you invested– when people realize this, that’s when the bubble bursts and you lose most of your investment. (By the way, Cisco still hasn’t reached their peak from 2000, even though the company is quite solid)
The other problem is, even if the company is in excellent financial shape and makes huge profits, you can still overpay for such company if the price is too high and when you buy based only on the rising price.
Think of it like this: imagine someone offered you a printer which prints $100 every year and will keep doing so until the end of times. How much would you pay for such a printer? I think somewhere around $1000 is fair, returning you the investment in 10 years and then printing you free money. What if I said the price is $100’000? Well, the printer would need 1000 years to repay you and thus even though it is great functioning machine, the price is simply too high.
The companies are basically those printers. Of course, it is a little more complicated, but the basic principle is the same: how much are you willing to pay for a company which generates earnings every year? If we set the limit (known as P/E ratio) to 15 for example and a certain company makes $20 per share, we are willing to pay maximum $300 for their stock.
The infamous growers
Fun fact: Tesla made $0.52 per share in earnings, meaning with our limit of 15 we would be willing to pay maximum $7.8. Tesla’s price is currently (15.11.2020) at 408.50, which gives it P/E of 781. If that’s not overvaluation, I don’t know what is.
Zoom Video Communications has a P/E of 463. Sure, it’s nice everybody is using their product and their revenues and earnings surely increased vastly during COVID-19, but people on the markets don’t care about “fair value” and buy the stock regardless of the price in relation to their earnings. That’s too bad for them, because right now, everybody is using Zoom and even if everybody continued studying and working from home forever, I don’t see how the company will magically multiply their earnings 15 times to reach somewhat moderate P/E of 30.
If these companies don’t start making astronomically huge earnings all of sudden (highly unlikely), the price will have to adjust and come down to a more fair valuation, because even though markets are not efficient all the time, prices revert to fair value over time.
How to deal with it
Why am I telling you all this? To illustrate that markets simply aren’t perfect nor efficient and you cannot buy a stock only because it’s been rising sharply or because everybody is using the company’s product.Once again, these often are good signs and doesn’t mean you cannot buy these stocks, you analysis just has to be more thorough.
You might argue that all this isn’t relevant and as long the price is rising, you will be making money. In finance, this is called “greater fool theory” and it implies as long there are more fools running in to buy the stock, you will be able to sell it for profit at a higher price later.
This approach is absolutely unsustainable, because people are not always so foolish as you might think and you are taking the risk that you are the last fool to get in. Put simply, you will get burnt relying only on price increase. Secondly, this approach is basically participating in a Ponzi scheme and resembles gambling. If someone wants to build wealth and get rich, you certainly wouldn’t recommend them playing roulette or black-jack. Then why do it yourself with stocks?
Bottom line is, if you inherited $1 million and wanted to buy some business, let’s say a restaurant or a coffee shop, I assume you would be stone-cold, meticulous and rational investor who examined everything– the business model, profits, debt, competition, product itself, the managers etc. you would want to know, whether the company will continue being successful and whether you’ll get your investment back.
Why should it be any different with stocks? It’s exactly the same and you should buy only stocks and companies you understand profoundly. For some reason, when people enter financial markets, this rationality disappears and people suddenly have gambling tendencies. You should definitely be aware of this and try to avoid subjecting to these tendencies.
From now on, I hope that you won’t get easily excited when other people are buying stocks because of rising prices or because the companies sell their products a lot, since prices tell you very little about the reality of the company and if the company is overpriced, the bubble will eventually pop, costing you a lot of hard-earned money. I also hope you will get as excited as I do when I find a profitable company, with good outlook for the future, managed by competent people and available for a good price, which constitutes a solid value investment.
Best of luck and be careful what and why you buy.