I think one of the most-repeated pieces of investment advice–”buy what you know‖can be quite problematic. Many people confuse what they see and hear with the type of hard-core knowledge necessary to make sound investment decisions. Take, for example, Apple and Facebook. Seemingly, everybody uses their products, is familiar with their rapid growth history, and can name the late legend Steve Jobs as well as “baby†CEO Mark Zuckerberg. Many may convince themselves they “know†these companies will continue to grow year in and year out.
However, stock valuations are not based on previous results, but on the future. The price of a stock is not based on what a company has done the past few years. It’s based on what people think the company will do over the next few years. Those investing in Apple and Facebook are generally “growth investors†who buy companies that have the capability to grow faster than competitors and the general economy. Yet, for companies such as Facebook and Apple, the reality can become “the bigger they are, the harder they fall.†That is, the higher the expectations, the more difficult it is to maintain the growth rate necessary to keep investors satisfied. This past summer these two remarkable companies were living proof of this axiom.
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Apple’s earnings report from the third quarter of 2012 reported $8.8 billion in profits, a 20% increase from the same period last year. Yet following this news, the stock fell 4%. Why? Wall Street had expected even better results. Analysts had predicted 31%
growth for the quarter. Plus the company shipped 26 million iPhones–26% fewer than it had the previous quarter. Apple had only missed expectations once in the previous 38 quarters. Ultimately, Apple was punished harder than most companies would have been in that situation, because many people came to view the company as invulnerable.Facebook’s story differs from Apple’s but similarly demonstrates the risk that comes with high-growth stocks. The company released its first-ever quarterly earnings report after going public, showing revenues at $1.18 billion, 32% higher than a year prior. As with Apple, what would normally be considered very strong growth was disappointing, because the quarter marked the company’s slowest growth rate since early 2011. On the day after the official news, the stock closed at $23.15–down 39% from its $38 IPO price from mid-May.
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With that information on the table, let’s look back at “buy what you know.†What we know to be true about these two companies–they have very devoted followings, great histories of growth, and so forth–is not enough going forward. For Apple, there are a handful of pertinent questions. Will the company convince millions who do not own an iPhone to buy one? Will current iPhone and iPad users upgrade to new versions? Moreover, what must-have, groundbreaking new product will succeed the iPod, iPhone, and iPad? For Facebook, will its trajectory keep moving upward or will it follow predecessors MySpace, Yahoo, and AOL? The company has roughly 955 million users worldwide; will it stagnate, grow to a billion, or rise to 2 billion?
All of which brings us to my view on high-growth stocks. First, always remember the difference between admiring a company and its remarkable products and buying its stock. Second, while it is OK to devote a small portion of a portfolio to high-growth stocks, I think the vast majority of a portfolio should go toward companies with far lower expectations baked in. I am a value investor, which means I have a strong preference for undervalued companies with low expectations built into their bargain basement prices. I like it when an out-of-favor company delivers fairly mundane growth; it can top expectations and see its stock rise. Simply put, I think stock investing works better when the bar is set low than when it is very high.