One of the most common and costly mistakes investors make is assuming that a great company must be a great stock to buy. It feels logical. If a business is growing fast, making huge profits and leading its industry, surely its shares are a good investment? The uncomfortable truth is that the answer depends almost entirely on the price you pay.
The company and the share are different things
A company is a business that sells products and earns profits. A share is a claim on that business, bought at a price set by the market. The quality of the business tells you what you are getting. The share price tells you how much you are paying for it. A wonderful business bought at too high a price can still be a poor investment.
Expectations do the damage
When a company is widely admired, investors bid its shares up in anticipation of strong future results. Eventually the price may reflect not just good results but near-perfect results for years ahead. At that point the company has to keep beating very high expectations simply for the share price to stand still.
This week offered a clear example. Several chip companies reported outstanding growth, including revenue several times higher than a year earlier, yet their shares fell because investors had already priced in extraordinary demand. Our Morning Market Brief covered the sell-off in Seoul and Taipei.
History is full of examples
During the dot-com era, many companies that went on to dominate the internet saw their share prices fall by more than 80 per cent after 2000. The businesses survived and thrived, but investors who bought at the peak waited many years to break even. The lesson is not that those companies were bad. It is that the price was too high.
How to tell the difference
Ask a few practical questions before buying a much-loved stock:
- What growth is already assumed? Valuation measures such as the price-to-earnings ratio show how much investors are paying for each pound of profit.
- How much has the share already risen? A huge run-up often means a lot of good news is in the price.
- What could disappoint? Slowing growth, rising competition or falling prices in the industry can hit highly valued shares hard.
- How crowded is the trade? If everyone already owns it, there may be few new buyers left.
Why ordinary companies can be better investments
Sometimes a dull business with modest expectations makes a better investment than a star. If little is expected, even decent results can lift the shares. This is the logic behind value investing, and it is why the FTSE 100’s mix of banks, energy companies and miners can hold up when glamorous technology shares fall.
The takeaway
Admire great companies, study them and keep them on your watchlist. But judge them as investments on price and expectations, not reputation. The best time to buy a great company is often when the market has temporarily fallen out of love with it.
If you want to understand how you make decisions like this, take the free Samuel & Co Trading Trader Assessment and see where your strengths lie.
