The ‘Wise Investment Advice’ That’s Not Always Worth Taking

Investing has many rules.

Some of them are useful rules.

Some rules are dumb.

Others have become a part of conventional wisdom even though there’s no proof to say they are right.

One of those conventional wisdoms is that you shouldn’t chase a stock price higher, because you’ll overpay.

That may seem to make sense — on the surface — but sometimes it’s a rule you’re better off ignoring…

Back in 2004 there was a hot initial public offering (IPO) set to hit the market.

Everyone wanted to get in on it.

But it wasn’t easy. Some worried that the frenzy could cause the price to list at too high a level.

Then, as the listing day approached, the demand seemed to fall. The company ended up listing the shares towards the lower end of the listing range.

Your editor wanted in. But we didn’t want to pay too much. So we set a limit price at a level we thought was fair. And then we waited.

It was a long wait. As it turned out, the stock price never traded near our limit price. It ended up costing us the chance to clock up a big triple-digit percentage gain.

What a mistake

That was 10 years ago.

The company IPO in question was Google [NASDAQ:GOOG].

We forget the price limit we placed for the order.

We just know that we missed out. We’ve never forgotten it. At the time, not paying too much seemed like the sensible thing to do.

If investors build a stock price up into a frenzy, it’s usually a wise move to stay on the sidelines. Wait for the steam (and the lunacy) to come out of the stock price and then jump in.

The mistake we made was in applying the same investing philosophy to a revolutionary and game-changing stock as we would to a retail or industrial stock.

When you’re looking at an established company that has limited growth, it’s only right that you should be careful that you don’t overpay.

(By the way, we don’t advocate overpaying for small-cap stocks. The low liquidity in small-caps means a limited number of orders can influence the stock price. With these stocks, the price can quickly rise and then fall. That’s why we always publish buy-up-to prices with small-cap recommendations. Here we’re talking about big-cap speculations.)

After all, if a company is only growing revenue and profits at 5% per year, if you overpay, it could take some time before you make good on the investment.

But that’s not always true with high-growth stocks.

With high-growth stocks sometimes you have to throw conventional valuation metrics out the window. High-growth stocks have the potential to grow revenue and profits by double-digit or even triple-digit rates.

And because these stocks are typically new companies bursting into new markets, it can be hard to value these companies or predict their growth rates.

That’s why these types of stock are so volatile. Investors just don’t know what to expect.

Don’t confuse stable with volatile

That’s why when most folks told investors to stay away from the Facebook [NASDAQ:FB] and Twitter [NASDAQ:TWTR] IPOs, we said that these were two speculations worth betting on.

Sure, they were risky. And to be honest, no one really knew how to value each company. But as a speculator that’s exactly when you should punt on a stock.

Think about it. No one in their right mind would say that Facebook and Twitter are perfect alternatives to investing in Telstra [ASX:TLS] and Woolworths [ASX:WOW].

The first two stocks are high growth speculations. The second two stocks are low growth, conservative investments.

In that case, why would you treat the high growth stocks in the same way that you’d treat low growth stocks?

You wouldn’t.

This is what investors get wrong all too often. They fall into the trap of thinking they need to analyse every stock on the same merits. That’s just wrong.

This is what we’ve written about for some time. You need to split your investments into different categories. You need an element of safety with some stocks, and an element of risk with other stocks.

Importantly, don’t lump the stocks together and think about them in the same way. You need to remember that certain stocks in your portfolio exist to do certain things.

Your conservative low growth stocks are for stability. These are the stocks that will pay you a good dividend. With any luck, you’ll never have to sell them.

On the other hand, the speculative high growth stocks are there for the volatility. You should hope that the share price will take off and give you big double-digit or triple-digit gains. But because you know they are risky, you also know they could crash and burn.

But you understand that. That’s why you take the risk.

It’s like Google all over again

The experience with Google and what we’ve seen happen to the Facebook and Twitter share prices came back to us as we watched Chinese online giant [NYSE:BABA] list on the weekend.

All the talk before the listing was how the company would have to raise the IPO price due to the demand.

They did. But they didn’t raise it high enough.

The stock price opened 38% above the IPO price. Talk about a windfall for those lucky enough to get in on the listing.

No doubt commentators and analysts will look on in horror at this rapid rise. They’ll talk about a price bubble. They’ll talk about the expensive valuation and say there are better deals elsewhere.

What they say may be partly true. But it misses the point. An investment (or a punt) in Alibaba isn’t about investing in a safe and reliable low growth company. It’s about investing in a potential game-changer.

It’s about investing in a company that’s one of the dominant players in China’s online market.

This is about speculating on what could happen as China’s middle class goes through explosive growth…and if the company can gain a foothold in the West.

Put it this way: There is huge growth potential for Alibaba, Facebook, Twitter, and other revolutionary companies involved in robotics and 3D printing.

This is why speculators invest in these companies. They’re looking for the next big investment trend. If these companies grow as much as their potential, then just like Google in 2004, 10 years from now all of these companies could look incredibly cheap…

…even at today’s supposedly inflated prices.

Kris Sayce
For Markets and Money

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Kris Sayce
Kris Sayce, dubbed the ‘Jeremy Clarkson of Australian finance’, began as a London finance broker specialising in small-cap stock analysis on London’s Alternative Investment Market (AIM). Kris then spent several years at one of Australia's leading wealth management firms. A fully accredited advisor in shares, options, warrants and foreign-exchange investments, Kris was instrumental in helping to establish the Australian version of the Markets and Money e-newsletter in 2005. He is currently the Publisher, Investment Director and Editor in Chief of Australia's most outspoken financial news service — Money Morning.

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