Most investors understand that investing in stocks is, fundamentally, an instance of ownership. Just as with the ownership of any enterprise, the owner puts his or her capital at risk in return for a claim on the profits. Your investment, whether it is as the sole proprietor of a small shop or as one of many shareholders in a multinational corporation, could turn out to be the next Microsoft (MSFT, $47) or the next Radio Shack (RSH, $0.33)--the potential is theoretically unlimited to the upside, but you could also lose every penny of your capital. Of course, being one of millions of shareholders is different from owning a small business. Just try buying some shares of Tesla (TSLA, $201), and then walking into the corporate headquarters and demanding an audience with Elon Musk. Your persistence might land you in a jail cell. The other difference, though, arises when your shares are publicly traded on a stock exchange, a feature that was captured by famed economist John Maynard Keynes with a brilliant metaphor in his classic work, The General Theory of Employment, Interest, and Money (1936).
Keynes postulated an imaginary beauty contest, sponsored by a newspaper that published the photographs of 100 women. The paper's readers were then challenged to pick the six most beautiful. The twist here is that those eligible to win the contest are not the pretty ladies in the newspaper--instead, the actual "contestants" are the members of the general public, who are vying against one another to guess which six ladies will garner the most votes. If you were serious about winning this contest, you would have to put aside your own preferences and tastes in beauty and think about what the public at large would find beautiful. You might think that the brunette with the angular facial features was the most striking woman you had ever seen, but if you think that the general public is inclined to favor blondes, you would focus your choices on the ones with the golden hair. The best strategy, Keynes noted, isn’t to pick the faces that are your
personal favorites. It is to select those that you think others will
think prettiest. Better yet, he said, move to the “third degree” and
pick the faces you think that others think that still others think are
prettiest. Similarly in speculative markets, he said, you win not by
picking the soundest investment, but by picking the investment that others, who are playing the same game, will soon bid up higher.
What is helpful about this analogy is that it reminds us of a basic truth of publicly-traded stocks--they go up only because other people buy them, other people who are big investors and traders thoughtful enough to do their buying after we've done ours. Most investors think that stocks appreciate in value because they have great sales and earnings growth, or at least the potential for such growth. That would seem to be true, but the missing link in that chain of causation is the necessary buying pressure from that big, nebulous population of investors and traders that we'll just refer to as "Wall Street."
Here's an old Wall Street joke that is apropos here. A broker persuades his client to buy 1,000 shares of stock in a promising company, at $5.00 per share. About a week later the stock has risen to $6.00, and the broker calls his client to tell him the good news. The client instructs the broker to buy another 1,000 shares. Then another week goes by and the stock is at $7.00; the client buys another 1,000 shares. The stock keeps going up, and the client keeps buying more shares. Some weeks later the broker calls the client to tell him that his stock has hit $12.00. The client tells the broker to sell all of his shares. The broker replies, "To whom?"
If we think about that bit of humor and the fictional beauty contest too much and for too long, we might never buy another share of stock again. That's because these scenarios remind us that when we buy stock in a publicly-traded company, we are, in essence, placing our financial fate in the hands of other people--Wall Street, that is. But before you become a complete cynic, consider the positive side of all this. Unlike perceptions of physical beauty, which tend to be highly subjective, the financial metrics of companies are much more objective. Those factors such as strong sales, margins, and earnings that make a stock attractive to us also tend to be the same factors that draw the attention of Wall Street--and the big money that provides the buying pressure.
Consider, for example, the case of Palo Alto Networks (PANW, $126), a cyber security company. A year ago (January 2014) PANW was trading at around $61 per share, and anyone who was paying attention to the news knew that hacking and cyber security threats were becoming a big issue. PANW then reported a series of quarterly earnings that beat analysts' estimates, and those Wall Street analysts started raising their earnings estimates and price targets for the stock. Over the course of 2014, the stock continue its move up, ending the year at $122 (up 100%). Many investors were no doubt scared off from the stock due to its high valuation (100 times earnings) and its strong advance. At $90 per share, the stock had already moved up 50%--this probably kept some investors sidelined. But big institutional investors kept buying the stock, and I have to think that part of the reason was their desire to own a problem-solving company that has the potential to be extremely successful in the high-profile area of network security. If you are an aggressive growth investor, you basically live for opportunities like this. Various statistical studies of winning stocks have shown that fundamental strength and growth in sales and earnings, combined with strong technical movement in the stock, are the attributes common to stocks that have outperformed the market significantly over long periods of time. The challenge, of course, is finding the stocks that have staying power as long term winners, as opposed to those of the "flash in the pan" variety. Having a growing addressable market such as the one that PANW faces certainly helps, as more companies spend more on protecting their networks.
While PANW may win the beauty contest, let's stretch the metaphor a bit further. Suppose we have two new entrants in the contest, a couple of beguiling, eye-catching beauties: one wears a sash bearing the name "bonds," and the other wears a sash reading "cash." If investors conclude, for whatever reasons, that there is too much risk in stocks, then bonds and cash may attract more votes. And then it may not matter how enchanting a stock like PANW is, if Wall Street just doesn't want to own stocks. It's hard to imagine that the charms of a near-zero real return in bonds and cash would be compelling enough to take the attention away from fast-growing stocks, but it can definitely happen if Wall Street concludes that a zero return is preferable to a negative one. So, while investors can have success in identifying the fundamental and technical strengths of stocks that will draw the buying power of Wall Street, the task becomes a bit dicier if the big investors pull away from stocks as an asset class.
Let me return to the issue of ownership before I wrap this up. For an example of classic ownership, I have to look no further than my own wife, who owns and operates a retail clothing store (The Pink Door, the Lilly Pulitzer Signature Store here in Memphis). My wife's focus is on increasing sales and keeping control over expenses, which is just another way of saying that she seeks to maximize her profits. At the end of any given business day, she can tell me how her sales came in and how they are tracking with the same period a year ago, and various other metrics of her store's performance. What she never mentions is anything whatsoever about what her business is worth. It isn't that she doesn't care about its worth--she just doesn't plan on selling it anytime in the near future. And, of course, if she maximizes her profits, the value of the business will increase over time. This is how, in economic jargon, she maximizes shareholder (ownership) value--by relentless attention to customer service, smart inventory decisions, marketing and promotions, etc. The point to appreciate here is that when we invest in a stock that doesn't pay dividends, we are entirely dependent on appreciation in the stock price for any return. And that appreciation comes only from other investors buying the stock.
So, as we search for those stocks with the attributes that will appeal to Wall Street, we need to keep an objective approach to the company's fundamentals. We should resist every temptation to fall in love with a "story" that isn't backed up by solid growth and other fundamentals. In other words, when we are judging the beauty contest, it is best to leave the beer goggles at home.
Life is short. Get busy.
Jim
Disclaimer/Disclosure: My family members and/or I own shares of PANW. Individual stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing stated here should be construed as the advice to buy or sell any security.
Consider, for example, the case of Palo Alto Networks (PANW, $126), a cyber security company. A year ago (January 2014) PANW was trading at around $61 per share, and anyone who was paying attention to the news knew that hacking and cyber security threats were becoming a big issue. PANW then reported a series of quarterly earnings that beat analysts' estimates, and those Wall Street analysts started raising their earnings estimates and price targets for the stock. Over the course of 2014, the stock continue its move up, ending the year at $122 (up 100%). Many investors were no doubt scared off from the stock due to its high valuation (100 times earnings) and its strong advance. At $90 per share, the stock had already moved up 50%--this probably kept some investors sidelined. But big institutional investors kept buying the stock, and I have to think that part of the reason was their desire to own a problem-solving company that has the potential to be extremely successful in the high-profile area of network security. If you are an aggressive growth investor, you basically live for opportunities like this. Various statistical studies of winning stocks have shown that fundamental strength and growth in sales and earnings, combined with strong technical movement in the stock, are the attributes common to stocks that have outperformed the market significantly over long periods of time. The challenge, of course, is finding the stocks that have staying power as long term winners, as opposed to those of the "flash in the pan" variety. Having a growing addressable market such as the one that PANW faces certainly helps, as more companies spend more on protecting their networks.
While PANW may win the beauty contest, let's stretch the metaphor a bit further. Suppose we have two new entrants in the contest, a couple of beguiling, eye-catching beauties: one wears a sash bearing the name "bonds," and the other wears a sash reading "cash." If investors conclude, for whatever reasons, that there is too much risk in stocks, then bonds and cash may attract more votes. And then it may not matter how enchanting a stock like PANW is, if Wall Street just doesn't want to own stocks. It's hard to imagine that the charms of a near-zero real return in bonds and cash would be compelling enough to take the attention away from fast-growing stocks, but it can definitely happen if Wall Street concludes that a zero return is preferable to a negative one. So, while investors can have success in identifying the fundamental and technical strengths of stocks that will draw the buying power of Wall Street, the task becomes a bit dicier if the big investors pull away from stocks as an asset class.
Let me return to the issue of ownership before I wrap this up. For an example of classic ownership, I have to look no further than my own wife, who owns and operates a retail clothing store (The Pink Door, the Lilly Pulitzer Signature Store here in Memphis). My wife's focus is on increasing sales and keeping control over expenses, which is just another way of saying that she seeks to maximize her profits. At the end of any given business day, she can tell me how her sales came in and how they are tracking with the same period a year ago, and various other metrics of her store's performance. What she never mentions is anything whatsoever about what her business is worth. It isn't that she doesn't care about its worth--she just doesn't plan on selling it anytime in the near future. And, of course, if she maximizes her profits, the value of the business will increase over time. This is how, in economic jargon, she maximizes shareholder (ownership) value--by relentless attention to customer service, smart inventory decisions, marketing and promotions, etc. The point to appreciate here is that when we invest in a stock that doesn't pay dividends, we are entirely dependent on appreciation in the stock price for any return. And that appreciation comes only from other investors buying the stock.
So, as we search for those stocks with the attributes that will appeal to Wall Street, we need to keep an objective approach to the company's fundamentals. We should resist every temptation to fall in love with a "story" that isn't backed up by solid growth and other fundamentals. In other words, when we are judging the beauty contest, it is best to leave the beer goggles at home.
Life is short. Get busy.
Jim
Disclaimer/Disclosure: My family members and/or I own shares of PANW. Individual stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing stated here should be construed as the advice to buy or sell any security.
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