|
Why hot stocks may not be so hot after all
During the boom in tech stocks 15 years ago, Jeremy Siegel, the finance professor and best-selling author, pointed out that “whenever companies, no matter how great, get priced above 50 to 60 times earnings, buyer beware.” In other words, when a stock price rises far beyond any reasonable measure of what the underlying business can generate in profits, a bubble is brewing. And it’s only a matter of time before it pops.
Hot stocks—be they the latest overhyped initial public offering (IPO) or the big gainer of the month—are prime examples of what Siegel is talking about. Sure, everyone wants to be in on the next big thing. But for a variety of reasons—most notably the risk of buying into overvalued stocks—retail investors should just stay away.
The odds of suffering a loss are already high enough when investing in individual stocks. Take the total stock market. Pick a random stock. The probability of losing money on that investment is almost 50 percent, according to an analysis by Thomas E. Berghage, author of “Stock Analysis in the Twenty-First Century and Beyond” (Xlibris, 2014). According to another study of stock performance from 1970 to 2010 by Jay Ritter, a professor at the University of Florida, IPO stocks lagged similar but established stocks by 4.8 percent in the first year after the IPO and by just over 8 percent in the second year. In the first five years, they underperformed similar stocks by 3.3 percent.
The reasons for that underperformance have to do with how quickly many stocks initially rise after an IPO, and investor psychology. Chasing the next big thing sounds great, except that other investors are chasing it, too. That demand can drive up prices into the danger territory, Siegel warns. Rising prices can also lead to a vicious cycle. Investors see the price gains and chase those returns. That increased demand drives prices higher still, enticing more investors.
The phenomenon can be explained by one of the most famous market bubbles of all time—the Dutch Tulip Bubble, which took place in the 1600s. It was recognized at the time that prices for tulip bulbs had become divorced from their inherent value as speculators—not collectors—became the primary source of demand. As prices rose, more and more speculators wanted to get in on the action, which pushed prices ever higher until they crashed, leaving many people in financial ruin.
Indeed, if you follow the money, you’ll see that the greatest amounts enter a market bubble close to the top. In the dot-com bubble, monthly net cash flows into equities peaked at about $35 billion soon before the tech-heavy Nasdaq peaked out.
From fund flow data to surveys of investor sentiment to personal accounts, there’s an abundance of empirical and anecdotal evidence showing that investors have a tendency to buy at high prices.
That’s especially true when it comes to hot IPOs because they garner so much media attention. According to a study last year in The Journal of Finance, “The Long-Run Performance of Initial Public Offerings,” people tend to overpay for stocks they read about in the news.
And because those hot stocks are in the news and overpriced, the same study found that three years after an IPO, most new companies are underperforming their closest competitors.
When you overpay for a stock, by definition you are consigning yourself to disappointing returns. That’s because valuation reverts to the mean over time. A good example of that is Microsoft (ticker: MSFT). The software giant’s valuation peaked in 2001 when investors paid almost $60 per share (adjusted for stock splits), or about 43 times trailing earnings. After the tech bubble burst, Microsoft stock spent the next 10 years languishing, its stock pretty much stuck in the high $20s. The stock didn’t start rising again until Microsoft’s profits caught up to its valuation. (In May 2015 MSFT was selling for about $47 per share, or about 18 times trailing earnings.)
Have a look at today’s hot stocks and you’ll see many similar examples of prices at large multiples to earnings. Tesla Motors (ticker: TSLA), for example, has been one of the market’s hottest stocks for the past couple of years. It doesn’t have a trailing price-to-earnings ratio (P/E) because it doesn’t have any past profits. By estimated earnings, which are only a guess on the part of Wall Street analysts, it has a P/E of more than 50. Remember that at that level, Siegel warns, “buyer beware.”
All you really need to know is this: Warren Buffett never, ever buys IPOs and fast-rising stocks. That’s because chasing them isn’t investing; it’s gambling. And when it comes to gambling, the house always wins.
This article also appeared in the May 2015 issue of Consumer Reports Money Adviser.
Consumer Reports has no relationship with any advertisers on this website. Copyright © 2006-2015 Consumers Union of U.S.
|
No comments:
Post a Comment