Over my 30 years of investing, I have been told, “Brent, you don’t understand the growth of this company or that company.”
I try to explain the fundamentals of business, but most people just shrug it off because they want to believe the stock they own is going to the moon. Facebook, Twitter and LinkedIn are some perfect examples. Yes, they have some great growth potential, but this growth is already baked into the stock price.
Let me pick on Facebook, which has continued to go up. Some have said, “Brent, looks like you were wrong.” What many don’t understand is investing is what I call the “endless race” — there is no finish line. People invest for their entire life and then when they pass away, their kids inherit those investments and, hopefully, don’t spend it on something foolish and lose it all.
Getting back to Facebook. It has traded as high as $72.59 and now trades about $59. In the year ending December 2013, the company earned 88 cents per share. Estimated for the year ending December 2014, earnings are expected to increase 43 percent to $1.26. Looking out to December 2015, the EPS estimate is $1.68 — a 33.3 percent jump from December 2014.
As a company becomes bigger, it becomes harder to keep up the high-growth rates on larger numbers. As the numbers become less exciting, the stock growth slows down and speculative investors start to pull away. This doesn’t mean it’s a bad company; it just means that it will begin trading as a real company and not some fantasy in which the high growth will go on forever.
As investors focus on how great the growth of this company or any highflier might be, they fail to look at the industry restrictions. What I mean by that is Facebook sells advertising; businesses spend only a certain amount on advertising.
It is estimated that next year, the world will spend $560 billion on advertising. Keep in mind that is all sources — radio, TV, newspapers, magazine and, yes, social media and the Internet. It is also estimated that Internet advertising will grow 14 percent to $132 billion. In other words, all companies can’t grow at high rate for very long because there will only be so many dollars to be spent on advertising.
And what if, down the short road, some other hot companies come out to compete for those advertising dollars? It’s like having a party for 10 and everyone is expecting to get a big piece of cake. Then two extra friends show up and they want cake as well, but the cake doesn’t get any bigger — everyone else’s piece of cake will be a little smaller. And don’t forget there are other companies such as Yelp, Zynga and Baidu already competing for those dollars.
The S&P 500 is trading about 17 times earnings, roughly 13 percent higher than the historical average of 15 times trailing earnings. Remember, this is an average of 500 companies. An average of 10 can be made up of the numbers 9 and 11.
It can also be made up from the numbers 5 and 15; this changes the whole dynamic of an average. If you have noticed over the past months, companies such as Tesla, Amazon and Netflix — all of which, by the way, have come down — are still bringing that average up.
It has also been pointed out that the disparity between the high PE stocks and the low PE stocks is the largest it has been in 13 years. And if you remember the dot-com bubble with their expensive PEs, well, welcome back: That is where the expensive stocks are trading. Some people never learn.
I can’t tell you when or for sure it will happen, although common sense tells me the high PE stocks will fall back to Earth. Studies have shown that when the spread between the high PE stocks and the low PE stocks is this wide, your low PE stocks tend to perform better than the expensive PE stocks going forward.
If you would like proof, read some of the books written by well-known money manager David Dreman, such as “Contrarian Investment Strategies: The Next Generation.” He backs up many of his strategies of buying low PE stocks with historical data.
So you have a choice: Keep going forward investing in the highfliers hoping that they won’t come down, or spend some time reading a 400-page book filled with great information that will make you a smarter investor.
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