Just
because it sounds cool, doesn’t mean it’s a good investment
Investors
spread myths about ways to invest successfully every day. Whether it’s the hot
stock tip received from an accountant or entrepreneur, or the IPO that your
broker is letting you participate in, it’s important for investors to separate
sex appeal from investment merit. Contrary to popular belief, the two often
don’t go hand-in-hand. Hence, this week, the focus will be on giving you the
low down on today’s most popular misconceptions.
“My employer is letting me buy its shares prior to its IPO. I don’t want to miss out on that opportunity.”
It’s often
not a good idea to buy stock in your employer, for a few reasons. The first
reason is diversification. Working full time for one employer already makes
your entire income dependent on this one company. While it may be a decent idea
to buy small amounts of company stock, particularly if it’s subsidized, it’s
still not prudent to excessively exposure your financial well-being to your
employer’s stocks, purely from a diversification standpoint.
The second
reason has to do with investment merit. While employers may make employee
purchase plans attractive, by allowing discounted purchases or matching plans,
investors must do their best to take an objective look at what they’re buying.
In other words, if a stock is grossly overvalued – admittedly not an easy
assessment to make – no matching plan or employer discount will make buying the
stock a worthwhile venture.
Finally,
investors would be well advised to stay away from most IPOs (initial public
offerings). An IPO marks the trading debut of a company’s shares on the public
markets, like the Toronto Stock Exchange. It’s really a company’s way of
raising money to finance its future growth. It raises money by selling small
pieces of ownership – its shares – in its equity. When launching an IPO, a
company will want to raise as much money as possible, while minimizing the
number of shares they have to sell.
If a company
is selling its shares in an attempt to fetch top dollar, that may be a sign
that it’s a bad time to buy those shares. Think about it. A company hires
investment bankers to help decide how many shares to sell, how to structure it,
what price to set, and when to launch the IPO. IPOs are often delayed when
stock markets hit the skids because a company wouldn’t be able to raise as much
money when share prices are down, overall. They wait until market conditions
improve (i.e. prices rise) before proceeding.
“What do you mean it’s not a good investment? An industry leader is a great company and a safer investment than some unknown.”
While this
statement makes intuitive sense, there are times when it couldn’t be further
from the truth. Not to pick on the obvious example, but Cisco Systems
epitomizes how good companies can be bad investments. Cisco was an industry
leader during the peak of the technology boom. Despite the fact that a global
economic slowdown has crippled the industry in which it resides, Cisco remains
in its enviable competitive position. So what has happened to its share price?
Over the past two years, the stock has fallen by nearly 60 per cent, and has
been flat over the last three years. That’s not exactly the type of stellar
performance most investors expect from industry leaders. I’m not commenting on
its future potential, but simply illustrating what can happen.
The lesson
to be learned from Cisco, and many other similar stories, is that every stock –
no matter how good the underlying business – has a limit to what it’s worth.
Drivers who love their Cadillac luxury vehicles are obviously willing to ante
up the $60,000 needed to buy a DeVille. How many Cadillac lovers would be
willing to pay $80,000 or $100,000 for the same car? Not many I’m guessing.
This is a
more simplistic example because buyers know the manufacturer’s listed price is
the high end. But with a stock, it’s much tougher to assess a value. And that’s
the major mistake most investors make with “good companies”. They either lack
the skills or time needed to value a stock, so they assume it’s good value at
any price – particularly if it’s just fallen in price.
Paying an
excessive price is speculation, no matter what the company.
“Boring companies aren’t worth my investment dollars. I want to invest in leading edge technology – in companies that will change the way we live and work. Now, that’s an exciting investment.”
What would
you say if I told you that a couple of this country’s best money managers are
buzzing about a company that converts and markets packaging products? Boring,
right? What if I told you that same company has seen its earnings per share
grow by 78 per cent per year over the past two years but trades at just 7 times
its latest earnings and below its book value? I can’t tell you the name of the
company because this information is very incomplete. However, my point is to
illustrate that companies that sound boring on the surface may in fact offer
exciting investment opportunities.
Marketing
departments and corporate spin-doctors heavily cloud the streets of Bay and
Wall. Successful investing is about cutting through the fluff and getting to
the real heart of any investment. It’s not about buying into a concept that
sounds cool or cutting edge; it’s about investing in what makes sense and about
paying attention to how much your paying for a company’s future expectations.
This is
most applicable to individual stock investing, but can also be applied to the
ever-growing universe of specialty mutual funds. Investors who are disciplined
and insightful enough to see through the fluff should be successful in their
investment endeavours.
Dan Hallett, B.Comm., CFP, CFA is Senior
Investment Analyst with Sterling Mutuals Inc. He can be reached at dhallett@sterlingmutuals.com Sterling Mutuals Inc. is registered as a
mutual fund dealer in Ontario, British Columbia, and Manitoba.