Surely a successful company results in a successful stock market investment. Not necessarily. At its simplest, the stock market – or any market – reflects the intersection between demand and supply. The more intensely participants want to buy, the higher the price that must be offered to induce sellers to sell. And vice versa.
Emotional swings between greed and fear often drive the decision to trade. When investors (and speculators) are greedy, they are eager to buy, often without regard to the price paid. This can lead to prices reaching irrational levels that are not justified by a stock’s valuation, based on company revenues, earnings, cash flow, or dividend yield per share. Additionally, when prices are rising, they develop their own momentum, which especially drives buying from computer trading models.
Recent examples include Zoom and Peloton. When the pandemic shut down much of the economy, investors quickly searched for beneficiaries of working and staying at home. Zoom’s business (teleconferencing) – and stock – did indeed zoom, with the stock rising nearly sixfold from March to October. Peloton’s (exercise equipment and remote classes) stock rose more than sixfold from March to its recent peak in January. DoorDash, a food delivery service, went public in December with a market value of more than $58 billion. Things can change quickly, however. Since those high points, Zoom’s stock has fallen by nearly 50%, Peloton’s by 40%, and DoorDash’s by 30%. This is despite the broad stock market setting record highs. Momentum trading exaggerates prices on the way up, as well as on the way down.
The unprecedented amount of money pumped into the economy by the Federal Reserve recently has also inflated many markets, including artwork and Bitcoin. Wittingly or not, buyers – or holders – are playing the “greater fool game” of counting on being able to sell at a higher price to someone even more foolish (and heedless of the history of market bubbles). At times like this, a company’s quality apparently doesn’t matter. For example, over the past year, the lowest-quality companies (based on the financial condition rated by S&P) have had stock market returns 48 percentage points higher than the highest-quality companies.
Though it may be counterintuitive, it is not a company’s growth record or prospects for future growth that drives market prices, but unanticipated change – i.e., expectations versus reality. There are many factors that influence stock prices, even simply money flowing in or out of a stock, unrelated to business fundamentals, such as shutting down and liquidating a large fund. But expectations are critical.
Just like “concept” stocks Zoom and Peloton, even established, dominant companies can pose unexpected risks of poor returns because of overly inflated expectations for industry dominance or future growth. Take the “one decision” (buy and hold, set it and forget it) stocks of the Nifty 50 popular in the 1970s, which included Coca-Cola, Eastman Kodak, Hewlett Packard, Polaroid, and Xerox. Slowing earnings growth and technological obsolescence made a number of them poor investments, at least relative to the broad market.
Could the same thing happen to today’s stars? It does seem inconceivable – as it always does – but the leaders could lag the market in the years to come. The reason wouldn’t matter; it could be slower-than-forecast growth, technological change, or adverse government regulation (of the Big Tech companies, for example).
Instead, a better investment might be a company that is unpopular because of current, temporary difficulties or a business that is stodgy but well run (such as a grocery chain) and inexpensively priced. That latter approach – which we embrace – can improve the risk/return tradeoff through a “margin of safety.”
Particularly at a time like this, late in a market mania, we’re less interested in chasing yesterday’s winners and more interested in looking for market underdogs. Our advice to those drawn to the allure of high-flying stocks? Hard as it is, try to keep your head while others are losing theirs. As Warren Buffett said, “Our capital is underutilized now … It’s a painful condition to be in – but not as painful as doing something stupid.”