{"id":3116,"date":"2020-07-12T15:57:22","date_gmt":"2020-07-12T15:57:22","guid":{"rendered":"https:\/\/thefinanceghost.com\/?p=3116"},"modified":"2020-07-12T15:57:22","modified_gmt":"2020-07-12T15:57:22","slug":"is-a-good-company-always-a-good-investment","status":"publish","type":"post","link":"https:\/\/thefinanceghost.com\/index.php\/2020\/07\/12\/is-a-good-company-always-a-good-investment\/","title":{"rendered":"Is a good company always a good investment?"},"content":{"rendered":"

T<\/span>his question was posed to me last week by a reader and makes perfect sense. Simply put, is it always true that a strong company with a great brand and solid products is also an attractive investment?<\/p>\n

Immediate logic dictates that the answer must be yes \u2013 after all, the world\u2019s most famous companies are almost indestructible, aren\u2019t they? Isn\u2019t life in the spotlight exactly where investors should be playing?<\/p>\n

Without delving into high profile corporate failures, which unfortunately do occur from time to time, there are two other topics that are worth touching on in answering this question:<\/p>\n

    \n
  1. Adequate return for risk<\/li>\n
  2. The concept of price vs. value<\/li>\n<\/ol>\n

    [the_ad id=”3223″]<\/p>\n

    Return vs. risk<\/h4>\n

    The absolute foundation of investment theory is that a riskier investment must offer a higher return.<\/p>\n

    Risk is usually measured by volatility, standard deviation and related measures which try to capture the likelihood of the value of the investment changing. There\u2019s another important concept called kurtosis or \u201cfat tails\u201d \u2013 all you need to understand here is that extreme events are often more likely to occur than traditional statistical models would predict.<\/p>\n

    The Global Financial Crisis or lockdown are perfect examples of these. They are also known as \u201cBlack Swan\u201d events when they are extreme events to the negative. Positive extremes are of course also possible, but long-term investors don\u2019t mind those. Traders and hedge funds certainly do, as they sometimes bet on a negative or flat outcome vs. an extreme positive.<\/p>\n

    Because of this, it is possible that a money market account paying 5% is as attractive an investment as a listed company returning 15%. It all comes down to units of return per additional risk taken on, measured neatly by a method called the Sharpe Ratio.<\/p>\n

    We won\u2019t delve into the Sharpe Ratio here as it\u2019s a topic deserving of its own article, but the critical thing to understand is that two investments can be equally attractive despite offering different returns, purely because their risk profiles could be very different.<\/p>\n

    If you have the option of taking R5 right now on a risk-free basis, or the option of trying for a larger number (but also the risk of zero), what would the larger number have to be before you are willing to take the gamble? That\u2019s the way risk-adjusted decisions work.<\/p>\n

    Before I explain how this relates to market-leading companies as investments, we need to touch on another concept.<\/p>\n

    Price vs. value<\/h4>\n

    Warren Buffett is over-quoted in financial writing to the point of nausea, but it\u2019s for a good reason. In some contexts, he explains it best.<\/p>\n

    \u201cPrice is what you pay. Value is what you get.\u201d \u2013 Warren Buffett<\/p>\n

    The point is that the price of something isn\u2019t always equal to its value. The art of \u201cbeating the market\u201d over time depends entirely on an ability to consistently identify undervalued companies i.e. value < price.<\/p>\n

    If you invest in companies where price > value, then at some point your return will likely be below that of the market. That isn\u2019t to say that you\u2019ll lose money, but you won\u2019t have maximised your return for the risk you are taking on.<\/p>\n

    What does this have to do with famous companies?<\/h4>\n

    Famous companies sometimes trade at such high multiples (calculated as share price divided by profit for example, or sales) that they simply aren\u2019t attractive investments anymore. No matter how great a company is, there\u2019s always an element of risk. Shareholders need to be compensated for this risk and that won’t happen if the entry price is too high.<\/p>\n

    If investors have pumped up the share price to lofty heights, it might not be a good idea to climb in at that stage.<\/p>\n

    We are seeing this right now in the US market, as tech companies keep reaching new highs. Tesla in particular has shot the lights out, becoming the most valuable automotive company in the world despite being loss-making every year.<\/p>\n

    Tech investors are completely focused on the future, with little regard for the current financial positions of these companies. It works in some cases and fails horribly in others (like WeWork which failed to list successfully because it is little more than a property company pretending to be a tech company).<\/p>\n

    I\u2019ve written before about how I\u2019m worried that Netflix is a media company pretending to be a tech company<\/a>. Is Tesla just a car and renewable energy company pretending to be a tech company? Only time will tell as the world\u2019s established car manufacturers start to fight for electric vehicle market share.<\/p>\n

    I\u2019m personally loathe to bet against Porsche in that fight\u2026<\/p>\n

    Answering these questions isn\u2019t easy, but the key point is that these famous companies aren\u2019t automatically great investments. If they are overvalued, they might not provide an adequate return for the risk you are taking on as a shareholder.<\/p>\n

    Is the rulebook being thrown out?<\/h4>\n

    Having said all this, we are witnessing historic times in the market. It feels like tech could be the new gold, as capital flocks to the world\u2019s largest tech companies in times of need. Gold is only a safe haven asset because people believe it is a safe haven. It\u2019s a self-fulfilling prophecy. That belief can change.<\/p>\n

    If tech goes the same route, traditional valuation techniques may not be appropriate anymore for tech companies. In that case, you aren\u2019t betting on the specific tech brand anymore (e.g. Amazon), you\u2019re betting on a sustained structural shift in investment theory.<\/p>\n

    I\u2019m not saying it isn\u2019t possible. I\u2019m just saying it\u2019s riskier than most people will warn you about.<\/p>\n","protected":false},"excerpt":{"rendered":"

    This question was posed to me last week by a reader and makes perfect sense. Simply put, is it always true that a strong company with a great brand and solid products is also an attractive investment? Immediate logic dictates that the answer must be yes \u2013 after all, the world\u2019s most famous companies are almost indestructible, aren\u2019t they? Isn\u2019t …<\/p>\n","protected":false},"author":2,"featured_media":3117,"comment_status":"open","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_mi_skip_tracking":false,"_monsterinsights_sitenote_active":false,"_monsterinsights_sitenote_note":"","_monsterinsights_sitenote_category":0,"footnotes":""},"categories":[26],"tags":[197,194,193,195,196,198,99,192,41],"aioseo_notices":[],"_links":{"self":[{"href":"https:\/\/thefinanceghost.com\/index.php\/wp-json\/wp\/v2\/posts\/3116"}],"collection":[{"href":"https:\/\/thefinanceghost.com\/index.php\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/thefinanceghost.com\/index.php\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/thefinanceghost.com\/index.php\/wp-json\/wp\/v2\/users\/2"}],"replies":[{"embeddable":true,"href":"https:\/\/thefinanceghost.com\/index.php\/wp-json\/wp\/v2\/comments?post=3116"}],"version-history":[{"count":0,"href":"https:\/\/thefinanceghost.com\/index.php\/wp-json\/wp\/v2\/posts\/3116\/revisions"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/thefinanceghost.com\/index.php\/wp-json\/"}],"wp:attachment":[{"href":"https:\/\/thefinanceghost.com\/index.php\/wp-json\/wp\/v2\/media?parent=3116"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/thefinanceghost.com\/index.php\/wp-json\/wp\/v2\/categories?post=3116"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/thefinanceghost.com\/index.php\/wp-json\/wp\/v2\/tags?post=3116"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}