The stock market's recent gains have been largely driven by the increasing popularity of large-cap technology companies. They include businesses such as Apple (AAPL, Financial), Facebook (FB, Financial) and Amazon (AMZN, Financial) that have recorded stock price growth of 33%+ since the start of the year.
Some investors may be contemplating purchasing these companies, as well as others, because they are popular among their peers. However, I think this is a dangerous strategy. It may mean you overlook possible flaws and underestimate potential threats to their share prices.
A better idea may be to follow Benjamin Graham's views on the subject and take a company's fundamentals into consideration prior to purchase.
The risks of buying popular stocks
Rising stock prices do not always reflect improving company fundamentals. Short-term stock price movements are often heavily influenced by investor sentiment. As the VIX index's decline since the 2020 bear market shows, investors have become less risk averse since March. The index has a reading of 22 today versus 82 in March, with a lower number suggesting investor mood is more optimistic.
In addition, this year's rising stock prices are based on increasingly optimistic earnings forecasts that may be difficult to meet in many cases. In my view, earnings estimates could be subject to major change as a result of a fluid economic outlook. Companies that miss their forecasts could deliver disappointing share price performances because they trade on valuations that already assume a positive future is ahead.
Therefore, today's popular stocks could be hit hardest in a subsequent market decline. The current bull market is very unlikely to last forever. Richly-valued stocks that have risen quickly in recent months may underperform their cheaper index peers in the long run.
Focusing on company fundamentals
Using company fundamentals when buying stocks may lead to a more efficient capital allocation compared to buying popular stocks. Benjamin Graham was always an advocate of using facts and figures to determine where to invest. As he previously said:
"Evidently, stockholders have forgotten more than to look at balance sheets. They have forgotten also that they are owners of a business and not merely owners of a quotation on the stock ticker. It is time, and high time, that the millions of American shareholders turned their eyes from the daily market reports long enough to give some attention to the enterprises themselves of which they are the proprietors, and which exist for their benefit and at their pleasure."
In my opinion, analyzing a company prior to purchase can reduce risk. It may highlight threats to the business that are not immediately evident at first glance, or that have not been identified by other investors. This may be particularly relevant in today's uncertain economic environment, where investor sentiment towards popular stocks can quickly change.
Disclosure: The author has no position in any stocks mentioned.
Read more here:
- Joel Greenblatt: Don't Forget the Investing Basics in a Bull Market
- Howard Marks: Be Careful in a Bull Market
- Warren Buffett: Don't Waste Time Trying to Predict the Future
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