Scrutinize Company, Not Just Share Price

 | Apr 21, 2014 | 3:00 PM EDT
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One of the biggest mistakes stock market participants make is judging a company's success and quality based on what the stock price does. In other words, the stock price is used as the ultimate barometer in judging a company. A rising stock price is taken as gospel that the company is best in class while a declining stock price is viewed as the scarlet letter forever branding a business as inferior.  

If investors want to change one behavioral pattern that would have the most compelling effect on their returns, I would argue that it should be understanding the difference between a stock price and the underlying company.

Stock prices are determined each day by thousands of votes. Every single day, a stock price is subject to the emotional tendencies of human behavior. So from that short-term perspective, a stock price really has no bearing on the true value of a business. In the short term, stock prices represent information about whether the underlying company is being valued at an attractive price. In the short term, prices do not reflect the long-term durability (or the long-term deterioration) of a business.  

When Facebook (FB) went public at $36 a share, the immediate pop over $40 was an example of short-term effect that optimism has on stock prices. In the coming weeks, as the optimism faded, the shares plummeted to less than $20 and the mood has shifted to one of pessimism.

During this trip, the novice investor let stock prices dictate his behavior: he loved Facebook when shares were rising above $40 and couldn't wait to sell when shares fell through the floor. The smart investor let the stock price guide his investment thinking, which went something like this: Facebook offers no value when shares were trading for $40 but now that shares have fallen to $17, the company has a far more favorable valuation and may be an attractive investment opportunity.

The selloff in on part of the tech sector, names like Netflix (NFLX) and Twitter (TWTR), is being replaced with increased buying with names like Cisco (CSCO) and Microsoft (MSFT). To many, this action is being interpreted as a good bye to names like Twitter, Netflix, and the others. Instead, investors should understand that a quality company can be a terrible investment at the wrong price while an inferior company can be a quality investment at the right price. Tech stocks are not the only victims. Chipotle (CMG), one of the highest quality businesses in my view, is not a great investment today. The optimism surrounding the company has distorted the stock price. Conversely, were some pessimism to come in and send shares lower, you would have a great company that perhaps became a better investment.

Remember Apple (AAPL)? It was the going to be the first trillion dollar company and $1000 stock price. It's still a strong cash cow, yet the optimism is gone.

Stock prices are bits of information. As such, they should guide you, not dictate your investment decisions.

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