Part of the reason picking winning stocks is so difficult is because a great company isn't always a great investment. That may sound like a contradiction in terms, but when it comes to investing and all the complexities of modern markets, it's also a very real potential outcome.
Some of it owes to general market psychology. The market is driven by literally millions of investors. What one person thinks is a great company, another ignores. And if enough investors ignore a company, its success doesn't translate to price action.
There's also the question of exactly what constitutes a great company. At first glance, strong fundamentals would seem like a logical definition. But if that were the case, investing would be pretty easy. Simply pick the companies with the strongest fundamentals, invest your money and wait for the elevator to rise.
Unfortunately, that's not the way it always plays out. Before a stock becomes hot, it has to get noticed, particularly by institutional investors. To do that, the company has to have some quality that excites those investors. Often, that's little more than a brilliant-sounding concept. But if a company can grow on that concept — even without strong fundamentals — it can easily outperform what might be considered a great company by more traditional definitions.
Let's take a look at some of the reasons a great company isn't always a great investment.
The Company Is Being Ignored by Wall Street
A company stock price doesn't take off just because it's a good company. It takes off mainly because it's drawing investor interest. Since so much of the market today is held in mutual funds and exchange-traded funds (ETFs) or institutional positions like pensions and insurance companies, investment flows are largely driven from the top down.
No matter how good a company is, if it doesn't draw the attention of the big funds and institutions, its stock price growth could be limited. A great company could go for many years without being noticed, causing its stock price to languish. Here's more about stock growth investing.
The very low P/E doesn't necessarily mean the company is a good investment. If it pays an above-average dividend and shows at least slow, steady stock price growth, it could still be a winning position. It just might not be the kind of stock likely to make you rich.
A Great Company Can Still Have an Excessive Valuation
This is the exact opposite of the above situation. A company could be so popular with institutional investors, that the stock price can rise to levels that may not be sustainable. It may in fact be a great company — well managed and offering winning product lines — but its fundamentals don't justify its stock price.
An institutional favorite like Amazon can pull that off just because it is an institutional favorite. It's also dominating the rising home-delivery market, and Wall Street loves nothing so much as dominance. But a far less recognized company could end up being dumped by funds for excessive valuation.
Profitability Doesn't Guarantee Stock Price Growth
Many of the most popular stocks have little or no earnings. One example is Tesla (TSLA). Despite having negative earnings, the company stock price doubled from $181 in December 2016 to $383 in June 2017. Though it's largely leveled off since then, it's still trading at over $300 per share. That, despite the fact that the company has a current earnings per share (EPS) of minus $13.98 (as of July 12, 2018), which means the company is losing nearly $14.00 per share per year.
Investors are often more interested in business concepts than profitability. In the search for a piece of The Next Big Thing, they may ride a money-losing company higher, while completely ignoring profitable ones. In the case of Tesla, the interest is in the company's electric cars and batteries.
Another example is GoDaddy (GDDY). The company stock increased from $42 a share a year ago to the current level of $77 — an increase of more than 80% in one year. Yet the company is currently trading at 100 times earnings. In an internet driven world, investors may be more drawn to the fact that GoDaddy is the world's largest web host provider than its profitability.
Good Companies Can Still Be Taken Down by Falling Markets
No matter how good a company is, its stock price can still decline in a falling market. This is especially true in a general bear market. That's because bear markets tend to take down good stocks along with the bad. This happens because bear markets generate indiscriminate selling. Investors just want to reduce their exposure to stocks or liquidate their positions entirely.
If you happen to buy into a good company just before a bear market takes over, the stock price could go down and stay down for years. This is more of a timing issue than anything else. You'll simply have bought in at the wrong time. But it also highlights that even a good company stock is not immune to conditions in the general market.
A great company may have too many shares of stock outstanding. It may be that they started out that way, or they continued to issue more shares along the way. However it comes to be, a large number of common shares outstanding will reduce the EPS.
For example, if a company has a $150 million profit on $1.5 billion in sales, it has a very healthy 10% profit margin. That would indicate a strong performance. But if it has 500 million shares outstanding, its EPS will be just $0.30. Despite the fundamental strength of the company, the number of shares outstanding is diluting its share performance.
At $0.30 EPS, the stock could trade at $15 and have a relatively high P/E ratio of 50. That will put a serious lid on stock price growth, even if the company's revenues and earnings are growing.
This is a major reason companies buy back their own stock. By buying back stock, they reduce the number of shares outstanding, which improves their EPS. For example, even if the company reports flat earnings, if they buy back 10% of their outstanding stock, EPS will rise by 11%.
If a great company isn't buying back its own shares, institutional investors will likely avoid buying into the stock.
One reason the company is great may be because it has very little debt. And it may have very little debt because it's financing expansion through the issuance of stock, rather than borrowing from banks or floating bond issues.
Fundamentally, the company may be financially sound. They have low debt levels and very little in interest expense. But the practice of issuing more stock to raise capital is acting as a drag on earnings-per-share growth.
The Company Is in a Declining Industry
No matter how great a company is, investors are likely to avoid its stock if it's in a declining industry. In the examples of Tesla and GoDaddy above, we see how investors deemphasize profit in favor of rising trends. In these cases, it's electric cars and the expected continued growth of the internet.
But if a company is engaged in an industry that's experiencing a general decline, it'll suffer “guilt by association.” For example, if the company is in the office supply business and that industry is in decline (probably because of the growth of the internet), the stock of the company may decline with the industry. It doesn't matter that it's a great company. Investors will see only that future growth potential is limited by the declining state of the industry.
The Company May Potentially Be Facing a Scary Contingency
Often the biggest factor affecting the price of a company's stock is taking place outside the company itself. All businesses operate in a multitude of environments, including political, geopolitical, regulatory, legal and social. Though none may be a part of their core business, the company could still be affected by any of those environments.
For example, let's say the company is engaged in an industry that's facing new regulations. The company may be very well run, but the prospect of a set of crippling future regulations could either limit its future growth or create the impression of expected decline.
A class action suit against the company or industry could also cause the stock of even a great company to go down and out for a very long time. Alternatively, a company may face an uncertain future if it has significant exposure in an unstable country or region. And in an era of increasing social media, sometimes just a change in popular perception can send the company stock plummeting.
Final Thoughts on Why a Great Company Isn't Always a Great Investment
The fact that great companies aren't always great investments emphasizes the reality that investing isn't easy. This is a major reason so many investors choose mutual funds and ETFs, instead of direct ownership in individual companies.
Even if you do all your research and identify companies that look like “can't miss” opportunities, they may very well miss anyway. And often for reasons you never considered.