An article titled 3 Stocks That Can Do Well in This Economy was recently submitted for my weekly roundup. I didn’t include it, as I wanted to discuss it more thoroughly.
The author, Mark Riddix, made a compelling case for the success of the three companies in question. But I wasn’t entirely satisfied as to why the stocks of those companies would be good investments.
Quick reminder: The fact that a company is growing (or is going to grow) does not by itself mean that its stock is a good investment. For a stock to be a good investment, there must be reason to think that its future growth is not already reflected in its price.
Said differently, for a stock to earn above-average returns, the company must do better than the market expects it to.
You vs. The Market
Let’s imagine that you’ve found a company that you’re confident is going to grow, and based on your calculations it looks like the market is underestimating that future growth. In other words, it looks to you like the stock is underpriced.
Whenever you think that the market has priced a stock incorrectly, there are two possible explanations:
- You know something the market doesn’t know, or
- The market knows something you don’t know.
If the current market price for a stock is below what you think is appropriate, either you know something positive about the stock that the market doesn’t know, or the market knows something negative about the stock that you don’t know.
Scenario #1 is the jackpot. But thinking you’re in scenario #1 when you’re really in scenario #2 sets you up for a nasty surprise.
How Can You Tell the Difference?
So how can you tell which scenario you’re dealing with? I’d argue that in most cases, you can’t. And if there’s no way to know, betting that you have more information than the rest of the market seems unwise to me.
The only two situations in which I’d be comfortable betting against the market would be:
- I’ve done enough research that I’m confident I know every single material fact about the company, or
- I have a specific reason to think that I have information that has not been noticed by the rest of the market.
Of course, each of those conditions is rather difficult to satisfy. And I suspect most of us have no interest in doing anywhere near the amount of research that would be necessary to do so.
I think most of us would be better off buying, holding, and rebalancing a lazy ETF portfolio.
My three stocks to buy right now? VTI, VEU, BND.
Hi. I'm Mike Piper, the author of this blog. I'm a CPA and the author of several personal finance books. The point of this blog is to show that investing doesn't have to be complicated. 
“I’ve done enough research that I’m confident I know every single material fact about the company”
Actually, I think it is: “I’ve done enough research that I’m confident I know every single material fact about the company, and I’m confident that I am able to come to superior conclusions based on these facts, than the rest of the market. I am also confident that I am able to tell the difference between luck and superior skill.” 🙂
You wrote:
1. You know something the market doesn’t know, or
2. The market knows something you don’t know.
but I would add a third possibility:
3. You and the market both have no real clue about the future growth based on analysis, but you like the company, have confidence in its management and you want to bet on the stock’s future growth not being reflected in the current price.
I think buying for reason #3 is ok as long as you understand it’s a pure bet not based on analysis.
Great post, Mike! I think you made your points very well.
@Susan: If you’re buying for reason #3, you’re not investing. If it’s a pure bet, it’s gambling. Too many people confuse the two and think they’re investing in a company when they’re just emotionally committed to the stock because they’ve put so much time into it.
Mike,
A scarier possibility:
Without knowing the future neither you nor the market can calculate the fair price for the stock so you both just make your best guess.
PS I loved your three “stock” picks.
@Paul, I agree, but would add that there’s nothing wrong with gambling if you know that’s what you’re doing and understand the risks involved.
Own VEU and VTI- you are so on the money I have nothing else to say!! Keep it up, Barb Friedberg ps this one’s going in MY link round up!
Great analysis, Mike. I learned something here.
I think something worth expanding on is the idea that “future” growth can be reflected in a current stock price. Every investor has a different time line, right? So the “future” for those companies mean different things to different people. To some, the future may be 6 months and they are out. Others might see it as 2 years. Others 20. I don’t see how a 20, or even a 2 year growth expectation can be reflected in price.
What’s the consensus on how much growth is reflected in price?
wrt your post and the 3 stocks, i realize Mark was referring to this “economy”, which I think we’re all assuming means 6 to 12 months. thus, your analysis of growth/price reflection holds up.
“What’s the consensus on how much growth is reflected in price?”
Theoretically, all future growth should be reflected in the current price.
In theory, a stock’s price is the present value of all of its future dividend payments (whatever they may be). Of course, the further out in the future you get, the more “discounted” the estimated dividend payments become, and the less they affect the current price of the stock.