When you ask people to name some of their most admired companies, they often name companies like Google, Apple, Coca Cola, Pepsi, GE, etc. When they first jump in to the world of stock market investing, they also get attracted to these stocks and buy them. Also, many of us are looking to get in to newly listed “cool” companies like Facebook, Linked or Twitter. But are these companies good for investment?
They may or may not be. In order to find better than normal returns (or else you would just be investing in a diversified stock market index) you have to identify companies that are undervalued and / or will experience higher than expected growth. For many of these companies either one or both of these conditions may not be true.
Why These Companies May Not Be As Good An Investment?
There are several reasons why stocks of good companies may not be a good investment (it’s just the basics of managing investment risk):
Analysts Research: Stocks of such companies are covered by many analyst. Analysts run many different types of forecasting model and develop projections for these companies. They perform extreme due diligence and publish research reports with many of the key indicators that sophisticated investors are looking for. If the company is expected to experience a big growth, chances are the current price of the stock represents that expectations. Some common traits of high expected growth companies are high PE ratios, high valuation compared to revenues, high valuation despite losses, and lack of dividends.
Deep Pocket Investors: These stocks are not just on the radar of small investors but they are also typically held by institutional investors who invest large sums of much in many of the big companies. If there are any attractive opportunities to invest in such companies, they often make big investments until such opportunities no longer exists.
Market Saturation: For many big companies that capture a large percentage of the market they operate in, there may be very limited room to grow any further. The lower growth rate would mean the company may experience a stagnancy and this could reflect in the in the returns it provides to its shareholders.
Popularity: Household name companies are popular amongst individual investors as they often buy these companies just because they are familiar with the products and brands owned by the company and not because these stocks may be good investments. This may create an additional demand for the stock which is not justified by its fundamentals and cause the stock to become over valued which can result in lower returns for investors in the stock.
Ligation Risk: Often big companies are involved in many litigations and can suffer severe losses due to fines and penalties against them. They may have to withdraw from certain markets (like Samsung had to withdraw from selling its tablet in Europe), they may be blocked from entering new markets due to local rules and regulations.
How To Avoid Falling in Such a Trap?
What one has to understand is that a good company does not imply that its stock will be a good investment and neither does it imply that its stock will be a bad investment. One has to look beneath the surface to first understand the value of the company and it growth potential. You should ignore the hype around a company and only invest if the fundamental and projections seems realistic to you and you see the company is managed by people who can deliver those projections. When making an investment choice, look at various factors related to the company, your risk profile and other investments in the portfolio.
What other factors do you look at when assessing companies?