Occasionally, even good companies can be bad investments. There are also situations where bad companies can be great investments.
In fact, groups of “bad” companies in declining industries have higher stock returns relative to groups of “good” companies over the long term.
This is weird. I know. Counterintuitive
In this post, I cover two critical investing lessons that can help you build wealth in the future.
Table of Contents
Good Company, Bad Investment Example
Here is Tesla’s stock throughout 2022, down 67%. Therefore, with hindsight, TSLA was a lousy investment in January 2022.
Tesla’s revenue grew in 2022, although earnings were relatively flat.
What is happening here? How can the stock price fall drastically while the underlying company is still growing?
You can buy a great company at a bad price.
In this case, TSLA was overpriced in 2022. You can see how the price skyrocketed in 2020 and 2021, as shown below.
But what causes prices to get so high?
The Source Of Short-Lived Speculative Returns
Two interesting effects lead to high prices and lower expected returns in the future.
The first is the herd effect. For this, I will invoke the Zebra. Have you ever seen a herd of Zebras? Good luck picking out a singular zebra.
Zebras get close to other Zebras to make it harder for predators to identify them as individual prey.
Herding is a survival mechanism baked into mammalian biology. And you, my friend, are a mammal.
So, how does this apply to stocks?
Excitement spreads through the herd of humans and feeds on itself. We build great stories or “castles in the air” around businesses or assets that fuel further price increases.
The news and social media only amplify this perpetual feedback loop of excitement.
This is nothing new. Speculation has been a consistent response to many emerging technologies:
- Rail Road Mania of the 1880s
- Hype around automobiles and telephones in the roaring 20’s.
- The dot-com tech bubble in the 2000s.
I’m not pretending like I don’t feel herd excitement. I do.
But I choose to take a step back, reflect on history and focus on my investing system.
Herd Effect and FOMO
The herd effect does not act in isolation. It has a synergy with Fear Of Missing Out (FOMO).
You (and I) measure loss relative to a baseline. Consider what happens when your friends or others make easy money in speculative assets while you miss out.
Your baseline is increasing. This feels like a loss, triggering loss-averse tendencies that are innate to human biology.
If everyone’s earnings increase by $10,000, but your earnings remain the same, you will feel like you have taken a loss.
Therefore, FOMO can trigger loss-averse tendencies that cause you (and me) to buy into speculative assets.
But by this point, the price is already inflated, and future expected returns are meager. FOMO causes us to buy high and sell low.
- Stocks drop, and prices are low? People panic sell.
- Stocks are up, and prices are high? People buy.
Firms are the only things humans avoid when they are on sale. To learn more, check out Behaviour and Investing: 7 Ways To Control Emotional Biases
Hindsight Bias
It is easy for me to see herd effects in hindsight. Everything is clear in retrospect; that’s the hindsight bias.
But it is hard to determine if you are in a bubble when you are in it.
My rule of thumb is that if you sense the excitement around an investment, it’s probably a bad investment.
Why "Bad" Companies Outperform "Good" Companies
Historically, groups of “good” companies have had lower returns relative to groups of “bad” companies.
I’m sure you know this, but a stock represents ownership in a business—a company.
But first, I will need to define a “good” business and a “bad” business.
What Is a Value Stock
Value stocks tend to have low price-to-earnings ratios (P/E) and low price-to-book ratios (P/B).
P/E ratios are low because investors are unwilling to pay a high price for earnings.
This normally occurs with businesses that have uncertain future profits, high debt loads, and declining revenues. A business like this is a risky investment.
I define value stocks as “bad” companies.
What is a Growth Stock
A growth stock represents a business with growing revenue and growing earnings. I define such a company as “good”.
Growth companies often proliferate new technologies. The future looks bright for these companies; therefore, they are less risky than value stocks.
Finally, growth stocks tend to have high P/E and P/B ratios. It makes sense that investors are willing to pay more for a given amount of earnings.
Why Do Value Stocks Outperform Growth Stocks?
Investors are compensated, via returns, for taking on risk. More risk = more returns. This is a central concept in the Capital Asset Pricing Model (CAPM).
- Value stocks represent risky companies.
- Growth stocks are less risky companies.
It would make sense that you would expect higher returns from value stocks. These extra returns are called the “value premium”; a key takeaway from the Fama-French 3 Factor Model.
You may say, “Jake, show me evidence for value stock outperformance.”
Evidence For Value Stock Outperformance
Value stocks have outperformed growth stocks (good companies) over the long haul in all global markets that I’m aware of. This effect is most significant when looking at small companies.
US small VALUE stocks (as a group) returned 13.5% annually from 1972 to the present (Jan 2023) versus 9.42% for US small GROWTH stocks over that same time frame.
You can run this assessment yourself at portfoliovisiulizer.com.
What about international value stocks?
The difference between value and growth stock returns in international markets was 7.68% per year between 1975 and 1995, with “value stocks outperforming growth in 12 of 13 major markets” (Fama & French, 1998).
The last decade (2010’s) was an anomaly where growth stocks outperformed value stocks. Growth has become inflated and is returning to earth, similar to 2000 Dot-Com Bubble.
The outperformance of value stocks occurs because of a fact well-known in finance:
Investors are compensated (via returns) for taking on RISK.
Growth stocks are low-risk companies. Earnings are growing, and the future looks bright. That’s why growth stocks have lower expected returns.
It’s counterintuitive that a group of bad companies would outperform good ones. But it makes sense when you look at risk.
Compensated Vs. Uncompensated Risk
Not all risks are “compensated” with extra returns.
For example, the risk associated with an individual company or sector is not a “compensated risk.”
Therefore, you should not expect higher returns by tossing your life savings into one company, even though it’s riskier. This approach is unlikely to build wealth since most individual stocks underperform the market.
Why are risks associated with an individual company not compensated?
Markets do not pay you to take on risks that can be quickly diversified away.
Today you can own 10,000 stocks around the globe with a click to buy low-cost index funds. By clicking that button, you diversified away:
- Company-specific risk
- Sector-specific risk
- Country-specific risk
This is why holding the entire basket of global stocks via low-cost index funds maximizes risk-adjusted returns.
Index funds diversify away nearly all uncompensated risks. This leaves you with compensated risks – the risks you get paid (via returns) to take. I cover this all in more detail in my posts intro to investment risk and the ultimate guide on low-cost index funds.
Note that the value premium (excess returns of value stocks) represents a “compensated risk”. It can be acquired by owning a diversified basket of stocks, where those stocks have value characteristics.
Individual Risk Tolerance
I’m not advocating that you own value stocks or stocks in general. I don’t know your risk tolerance or if you are ready to invest.
Some people have a higher risk tolerance than others. For example, an individual in the military with a pension (bond-like asset), stable income, and no consumer debt may be able to take on the extra risk associated with value stocks.
Others may not sleep well at night during a 40% portfolio crash (fair enough). They are not suited for a portfolio of 100% value stocks, and would need a large chunk of bonds in their portfolio.
A Point On Simplicity (And Total Market Index Funds)
Holding value stocks in a portfolio increases complexity.
Not only does complexity consume time and energy, but it also makes it harder to detach emotionally from volatility.
One way to mitigate this complexity is to hold all stocks (value and growth) via total market index funds. Then, no mental energy needs to be allocated to speculation.
For more on the benefits of simplicity, see 7 Ways Simplicity Helps You Grow Wealth.
Conclusion
Human psychology causes groups and individuals to do funny things. The herd effect and FOMO can drive asset prices high. And high prices can create situations where promising companies are bad investments.
When the excitement is high, future expected returns are often low. It doesn’t matter if the excitement surrounds a good business, bitcoin, tulips (see tulip mania) or housing.
In addition, I showed that a collection of value stocks has higher expected returns than a collection of growth stocks. You can thank the risk-return-relationship for this confusing reality.
I hope this helps you make better investing decisions, especially in times of speculation.
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Jake out.