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.”