Over paying through optimistic evaluation of the current hot stocks pushes them passed being "fully priced" as there is a feeling among market participants of not wanting to miss out. "Fully priced" means that all the potential good news and good opinion has been factored into the current price. If a firm then falls short of any of these lofty expectations its stock price will often fall significantly and in a very short period of time, despite the company announcing what many casual observers would say are ‘spectacular results'. This is the markets twist on the adage "What have you done for me lately?" to become "What will you do for me next?". Here is a good example of what I mean:
Shares of Apple Computer Inc., whose popular iPods led to higher-than-expected first-quarter results, nonetheless took a beating after hours, falling $3.27, or 4 percent, to $79.22 on INET. The stock, which has been trading near its all-time high recently, earlier closed at $82.49 on the NASDAQ.
The Cupertino, Calif., company said it earned $565 million, or 65 cents per share, compared with $295 million, or 35 cents per share, in the year-ago quarter. Analysts were expecting earnings of 61 cents per share. Revenue totalled $5.75 billion.
But Apple provided a more muted outlook for the fiscal second quarter, and said it expects revenue of about $4.3 billion, below the $4.63 billion analysts are looking for. The company added it expects earnings, excluding stock option expenses, of 42 cents per share. Analysts are expecting earnings of 48 cents per share.
NEW YORK (AP)
Aftermarket Movers: Apple Falls January 2006
So let's review the company's results. They earned $0.65 per share versus $0.35 in the same period one year earlier. That is an 85.7% increase in one year. The analysts were expecting $0.61 per share surpassing expectations by 6.6%. The company then said it estimated its total revenue would be $4.3 billion dollars in the next quarter compared to $4.63 billion analysts were expecting, a difference of -7%. The company also estimated that their earnings would be $0.42 per share versus analyst expectations of $0.48, a difference of -12.5%. And what was the result on the trading price of the stock? On the previous day the stock was trading over $86 and two weeks later it traded below $66; a drop of over 23%.
People are prone to this over optimism and over paying for a variety of reasons. One significant reason is the overwhelming amount of short-term news that is directed at us. If you listen to or read the market headlines frequently, you are sure to be inundated with the current hot trends or biggest disappointments. If you base your investment decisions on these daily gyrations, you will not only end up with poor performance and high commission fees but you will also have indigestion and a lot of anxiety over your portfolio.
The market participants are always trying to discount the future performance back to an appropriate price today. The theory behind this approach is sound but where it falls apart is in the estimation and assumptions made of future performance along with the knee jerk reactions based on the most recent financial results. Economists and analysts tend to fall in love with the story and believe their own hype too much. They simply become too optimistic and then price securities for this best case scenario. As the company in question grows at an amazing pace, the bar in the market gets set higher and higher. All the while more and more investors fall in love with the story as people focus ever more on forced promises and lofty expectations and less and less on fundamental financial information and rational, conservative expectations. This type of action is generally driven by people not wanting to ‘miss out' on this fabulous investment. At this point, the stock has ceased to become an investment and is now a speculation.
If you are conservative in your estimates, allow a margin of safety in your evaluation rather than a ‘best case' scenario outlook, you will be less frequently disappointed and you will avoid many of the large price declines more often because this approach keeps you away from the speculations. This conservatism means that you won't participate in the movement of a lot of the headline names because they are frequently fully priced at levels that can only be termed ‘speculative'.
I will say that there is nothing wrong with some speculating, as long as you are aware that you are doing exactly that! Most investors don't know or don't believe they are speculating and that becomes a problem. Speculating also requires you a lot more of your time and energy, not to mention your tolerance to wider swings in portfolio valuation. Watching swings in the value of our holdings is an area of investing where many of us need serious coaching, but that topic is for another day. In light of these factors, speculating should be avoided.
Investors on the other hand, who base their decisions on the values derived from the fundamentals of an investment, are the ones who achieve the best performance in the longer term and typically with less volatility. Being content to stay out of these highflying headliners is a lot tougher to deal with than it sounds. As human beings, we all feel more comfortable if we belong to a group, preferably the large, mainstream group. Very few of us would be able to refrain from buying a high flying stock that's making headlines (think of Nortel) while watching all those other folks grin like a Cheshire cat as they watch their holdings skyrocket.
These same speculators will likely hold these securities to long on the down side to realize the huge gains they had at one point, albeit on paper. For those of you who will be lured into the belief that you can trade and beat the market (while millions can't) remember that speculating is exactly like golf; it looks like fun, it seems simple and it feels great when you get it right. But how many of us can actually play a par round? If you can, how long did it take you to learn to consistently play that well?
The point here is simple; do not get carried away and pay too much for potential. Stay focused on the price that you pay for what you are getting now and only a moderate valuation for what you are ‘reasonably likely' to get in the future. What we really want to do is go bargain hunting for investments. And why not! Most of us shop around for a bargain on a TV or a car and we most certainly want a good deal on a house. So why would you not be just as prudent about your stock investments?