I have a client who frequently emails me about stocks that she thinks I should purchase for her account. Inevitably, these are the “hottest” stocks of the day. By that, I mean they are the stocks that generate the greatest interest among investors. Everybody is talking about these stocks and everybody is interested in buying them. Why? Inevitably, the reason is because their prices are going up. Frequently, these are cutting-edge technology companies that have real business models and they are disrupting the way things are done in their industry. They might be great companies with outstanding leaders, but they typically have little or no earnings. They only offer a hope that someday they will be extremely profitable. The current list of companies that fit the description includes Tesla Motors (TSLA), LinkedIn (LNKD), and Netflix (NFLX). My client was particularly interested in Tesla.
When it comes to investing, it is important to distinguish between a company and its stock. Tesla Motors is a great company. It is revolutionizing the automobile industry. It is doing something that most experts thought was impossible. Tesla is producing beautiful, sporty, electric vehicles that can travel long distances between charges. Elon Musk, the company’s co-founder and CEO, is a genius and a great business leader. There is little not to like about this company.
But the company is not the stock. Companies can be great for many reasons. Stocks are great only if they are selling for less than they are worth. And is difficult, if not impossible, to argue that Tesla Motors is a great stock. At its peak, the stock’s market capitalization reached almost $25 billion. That was almost half the market capitalization of General Motors (GM). Yet General Motors makes close to 10 million vehicles a year and generates $154 billion in sales. Tesla is hoping that someday in the future it will be able to manufacture just half a million cars each year. As of now, sales amount to just $1.7 billion.
Of course, there is one critical difference between the two companies. General Motors is not expected to generate much growth, while Tesla has very strong growth prospects. As a result, it makes perfect sense to pay more for a share of Tesla, but how much more? General Motors sells for just 0.3 times annual sales, 1.9 times book value, and 8.0 times expected earnings. Tesla sells for 9.0 times annual sales, 27.0 times book value, and more than 80.0 times expected earnings.
Tesla is an extremely expensive stock. In my opinion, it is too expensive. The company has a long way to go before it grows into its valuation. In other words, Tesla could exceed expectations in terms of production, sales, and earnings, yet the stock could remain stagnant or even fall. This is not to suggest that General Motors is a great investment. The company has had a host of problems and it even had to be bailed out by the government. However, if something were to go wrong today, chances are that General Motors would hold up better than Tesla.
There are many ways to invest in stocks. The simplest method is to buy an index fund. This is a mutual fund or an exchange-traded fund that mimics a particular stock market index. The thinking behind this strategy is that it is difficult, if not impossible, to consistently beat the overall market over the long term. This is exactly what most academic studies show. If you buy an index fund, you are guaranteed to do as well (or as badly) as the market overall. This kind of investing is referred to as passive investing.
The alternative to passive investing is active investing. This refers to a strategy of picking individual stocks with the hope that you can do better than the market. There are many forms of active investing. One common strategy is to focus on momentum. Like my client who likes Tesla, momentum investors choose hot stocks that are going up.
Another active strategy is to focus on value. Investors who focus on value are often called contrarians. This is because they prefer stocks that are out of favor and that generate little interest. Because they are out of favor, they tend to be cheap.
Interestingly, whether they prefer momentum or value, most active investors fail to beat the market over the long term. Of course, there are exceptions. Warren Buffett and Peter Lynch are two of the best known exceptions. Both of them are value investors who avoid hot stocks. They prefer to buy out of favor stocks that are selling for less than they are worth. Furthermore, they invest for the long term. In fact, if the price of a stock they really like falls, they don’t get upset. They simply buy more.
As for my client, I am happy to say that I talked her out of buying Tesla. She wasn’t happy with me at the time, but she is pleased now. After all, the stock is down about 30% since she wanted to buy it. At the same time, General Motors has risen 8%.