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Good Company vs. Good Stock

Vitaliy Katsenelson

Vitaliy Katsenelson

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This is an excerpt from a comment I read on Daily Speculation. It is such a common misperception that I had to write a response:

“Great stocks [Google, Apple] are to be owned. Companies who dominate their space are to be kept and allowed to grow. Those who have built fantastic franchise names should be accumulated. Buy Google over Yahoo. Apple over Dell. And most importantly, the speculator should be willing to hold on, eschewing the quick buck in search of the really big gains that can be achieved through diligence and patience.”


I could not disagree more with this conclusion. In the long run, the performance of a stock in isolation (ignoring the external environment, i.e. interest rates, risk, inflation) is the product of fundamentals (i.e. earnings and cash flow growth) and valuation (i.e. P/E, P/CF).

Google (GOOG) and Apple (AAPL) may have great fundamentals: their innovation has led and may continue to lead to high earnings and cash flow growth. But are they good stocks?  They may or may not be. But, more importantly, will they be good stocks at any price? No! If I were to follow the above conclusion, that since Google and Apple are great companies they are great stocks at any price, at any valuation – at 50, 500, 5000 times earnings, then I’d walk into an overvaluation trap.

Take a look at eBay (EBAY) in the late 90s: it was a great company (it still is), but it was grossly overvalued. So, if you bought it in the late 90s and held it until today, despite its earnings going up 100-fold, the stock is roughly at the same level it was then. I’d argue few would have the patience and conviction to hold it through the downturn the stock took in the early ’00s.  Most investing in the stock in the late 90s lost money on it.

One of the biggest mistakes investors make in investing is failing to separate a good company and a good stock. A great company’s (fundamental) performance is wiped out by valuation compression. This is the battle of two winds: the tailwind of earnings growth and the headwind of P/E compression. 

Also, with a high growth priced appropriately (even to perfection) there is no room for even a small mistake (no margin of safety) left in the valuation - a small disappointment (it doesn’t have to be much) will lead to a substantial decline in price. The latest performance of Starbucks (SBUX) and Whole Foods (WHMI) stocks is a great example of being priced for perfection and delivering slightly less-than-perfect results.

This myopia in differentiating between good companies and good stocks is not just limited to wonderful, exciting, larger-than-life (Google comes to mind here), fast-growing internet companies. The bluest of the blue chip stocks, like GE (GE), Coca Cola (KO), Home Depot (HD), Amgen (AMGN), Johnson and Johnson (JNJ) (and the list goes on) were all great companies that one “had to own” but were terrible (overvalued) stocks in the late 90s. Their earnings have doubled or tripled since but the stocks have not gone anywhere.

I think it was Benjamin Graham who said that “price is what you pay, value is what you get.”

About the author:

Vitaliy Katsenelson
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 3.8/5 (17 votes)

Comments

billytickets
Billytickets - 6 years ago
Couldn't agree more
JJINVEST
JJINVEST premium member - 6 years ago
Agree. I would like to add another pet-peeve I have is, people always talk about how good a company or a stock is based on how its stock price has appreciated. I cringe whenver I hear that. It is as though the earnings don't matter, the P/E doesn't matter, who the CEO of the company doesn't matter. and then the person comes back and say, "see. I am right. the stock went up by 30% in the past 3 months!" So short-sighted.
billytickets
Billytickets - 6 years ago
JJINvest be"thankful" for their ignorance. If the markets were"efficient" I would have to go back to a job.lol. Seriously I know what you mean buddy
ing_rivera
Ing_rivera - 6 years ago
Any business is worth the cash that me as an owner can get out of it, isn't feasible for Google to grow its cash flows from the actual $3Billion 25% for the next decade and then at GDP rate (with the minimum amount of capital, this is actually after ALL capex). In that case Google is not overvalued, is worth $217Billion on the dollar, and you can still get a good return even with a PE contraction in a decade. The internet is clearly growing fast worldwide and Google is well positioned with huge competitive advantages to take this growth. The thing I dislike the most is management investing in marketable securities most of the cash generated and having some small losses, so not creating a dollar of value for every dollar retained. The PE for a typical company that grows with barely capital is around 25, look at Moodys for example at current interest rates. So that will mean a 9% return in 10 years from holding Google stock, yeah you’re right not good enough. The return of the stock aren’t that great but I don’t think that Google is overvalued.

Walmart much better buy of course. Management had demonstrated a 15% on capital since ’98 and that capital being financed around 33% debt giving a leverage of 1.5 and return on additional equity at 23% and this even with the headwinds of Germany, South Korea and bad publicity. Simply extraordinary company. Most earnings converted to cash something that very few retailers do and this cash being around $15.5B next year, this company (on the dollar) it’s worth anything from $250B to $300B maximum. At $200 B it looks like is fairly priced and cheap relative to lower quality retailers. Actually its household penetration had doubled since 2000 while the ones for supermarkets and mass merchants had shrink. Exceptional economics due to wide variety and lower prices. I wouldn’t be surprised to obtain 15% returns from the stock and dividends from this stock in a decade. WMT is not overvalued like Google and the returns of the stock are great different to Google.

musto
Musto - 6 years ago
Why would anyone bother to own a "great" stock like Google?

The earnings yield is only about 2.5%. Even if they doubled their earnings

to yield 5%, it would still be lower than the risk free

short term government bonds.

I guess those people buying google now are not any different from

some of my friends buying cisco at the internet bubble peak.

At the time when I told them the same argument about cisco when it was valued

over $400 billion, they said that sort of looking at a quality high growth

stock was too simplistic.

Simplistic yes, but prudent nonetheless.


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