Just Because It’s a Good Company Doesn’t Mean It Is a Good Stock

For many of you who are serious followers of investing strategies and advanced personal finance blogs, this article might seem beyond elementary to you.  That being said, I thought we needed a post that went back to basics a little bit considering the number of fairly smart people I’ve been talking to recently who are making absolutely terrible investments, or at least making investments without any semblance of a proper decision-making process.  In fact, as a proponent of the whole efficient market theory, I’m somewhat worried about so many retail investors making ridiculous market-distorting decisions out there!

Do you ever have the experience where a person comes up to you and is like, “I read this headline in my newspaper this morning and it said I should invest in what I know.  I figure, that since I really like my car and grew up driving Ford’s [or whatever product you want to fill in] it should be a great investment.  I mean, who doesn’t drive these days right?”

 

Maybe Ford isn’t even a great example considering the trouble the car industry had a few years ago, but you get my point.  First of all, just because a company has a great brand name, that doesn’t make it a great company.  If you have an emotional attachment to a brand name, the potential for a destructive bias makes your judgement worse, not better!  Beyond that obvious connection though, I find myself a poor teacher when it comes to explaining why a great company is not always a great investment.  Whenever I try people tend to tilt their head and give me that confused puppy look.

Looking For a Great VALUED Company

Now it is true to some degree that a superb/elite company, is usually a decent long-term investment.  If a company is superb at what they do, no matter what the current stock price or any market turbulence going forward, they will probably do alright in the long run (see: McDonalds or Johnson & Johnson).  For the vast majority of stocks however, being a “good” company consists of a lot more than just producing a decent product, and having a couple catchy slogans.  Things like bank statements, P/E ratio, debt ratios, management teams, competition within the sector, long-term consumer trends, inventory stats, and dozens of other spreadsheet-esque considerations must be looked at in relation to the price of the overall stock before an educated decision can be made on if the stock is a good buy or not.

Warren Buffet says that when he looks at a potential company he might invest in he looks at the whole company, and thinks about what value he would put on the entire company given the metrics I just listed above and many more.  If that value is greater than what the current stock price suggests by a healthy margin, he buys the stock (often very aggressively) or buys the company outright.  The Oracle of Omaha has also been quoted as saying that you should only buy shares in a company if you would like to own it for the long haul.  This tells you exactly how much current price and market conditions have to do with the eventual success of a stock.

The Fruit Company

Ten years ago conventional wisdom was that Apple was pretty much done as a company.  Look how that turned out.  The bottom line is that few people have anywhere near the expertise and time commitment needed to accurately pick winners in the stock market.  In my mind this leaves the average retail investor with two choices:

1) Study several different books and blogs by a variety of authors and educate yourself to a level where you might stand a slim chance of beating the market average.

2) Passively invest in TD e-series funds, or in broad-based ETFs

This choice is an obvious one for me.  Give me the low-maintenance way to get the average return on equities as an asset class any day of the week, and let someone else pore over excel sheets trying to figure out which company is better than another.

Written by Teacher Man

TM writes about all things personal finance over at My University Money and Young and Thrifty. He intends to continue his quest for lifelong learning and hopefully help others along the way.

6 Responses to Just Because It’s a Good Company Doesn’t Mean It Is a Good Stock

  1. “In fact, as a proponent of the whole efficient market theory, I’m somewhat worried about so many retail investors making ridiculous market-distorting decisions out there!”

    This is why I’m not a proponent of the EMH – well, this and a long track record of beating the market. There’s just too much dumb out there to pretend it’s efficient. Heck, it turns out there are whole communities dedicated to investment by astrology.

  2. You are exactly right when you say good companies don’t equal good stock. But most of the time if you can read the quarterly and follow the company and calls you can determine whether are not to invest. Plus you have to be in it for the long haul. Not meaning you shouldn’t take profits or wait until the stock hits zero. Too often people buy stocks and they go down. But if you thought it was a strong company you should buy more on the pull back.

    For many however mutual funds and ETF. Personally I rather buy my own stocks and trade.

    • Teacher Man says:

      The large companies fudge their quarterlies so badly these days that I’m not sure how much I trust them, especially if they have any connection to the financial sector or China. I wouldn’t put mutual funds and ETFs in the same basket though, mutual funds are a decidedly worse option.

  3. I held Microsoft for years because it looked to me like a ‘good’ company – but they never rewarded their stockholders and I eventually sold at a small loss.

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