- This article is a warning for novice investors and a reminder for experts.
- When investing, nothing can be taken as a certainty as all are moving parts, especially financial metrics and prices.
- Comparing current prices to past prices doesn’t help much, while understanding the fundamentals does.
Investing shouldn’t be a comparative profession, but that is exactly what we do. We try to find the best stocks by comparing one to others, the best financial vehicle for our investments by comparing the options available, or we compare current prices with those of the past.
Unfortunately, comparative analysis more often than not gives us poor risk-reward assessments. In this article, we’ll discuss the pitfalls of comparative investing and what can be done to avoid making unnecessary mistakes.
Comparing Investing Metrics
Comparative investing is simple enough to explain. It’s when you compare investment metrics of one company with others and base your decision on that investment metric. This could be cashflow for miners, dividend yields for REITs, PE ratios, debt to equity, enterprise value to EBITDA, growth rates for social media companies, or short interest.
The greatest issue with such an approach is that it doesn’t protect you from systemic risks in a sector or the general market. The following figure compares the price of gold (GLD) with the three big names in gold mining, Barrick Gold (NYSE: ABX), Newmont Mining (NYSE: NEM) and Goldcorp (NYSE: GG).
Figure 1: Comparison of gold miners in last 18 months. Source: Nasdaq.
Although there are some differences among the above companies, all of them suffer when the price of gold declines and vice versa when it goes up. This is logical as their revenues and profits completely depend on gold prices, but it shows us that no matter the fundamentals, a stock will often move in sync with the general market. Investors who invested in ABX at the beginning of July are currently down about 37%.
Moving away from gold, another good example is natural grocers. It’s a sector that has been booming in the last decade but the entrance of supermarket behemoths like Wal-Mart (NYSE: WMT) and Kroger (NYSE: KR), increased number of smaller players, and a general negative sentiment toward supermarkets has lowered stock prices. We look at the stock performance and valuations of Whole Foods (Nasdaq: WFM), Sprouts Farmers Market (Nasdaq: SFM), KR, and WMT.
Of the above, the best performer in the last two years was KR, followed by WMT, with WFM and SFM being the worst performers.
Figure 2: Supermarkets in the last two years. Source: Nasdaq.
At the end of 2014, WFM had a PE ratio of 32.4, SFM’s was 53.2, WMT’s was 17.9, and KR’s was 20. The companies with the highest PE ratios became the worst performers while WMT underperformed even with the lowest PE ratio.
If we take the same example but take it 5 years back, KR is still the winner, followed by WMT.
Figure 3: Supermarkets in the last five years. Source: Nasdaq.
At the end of 2011, KR had a PE ratio of 12.5, WMT’s was 13.5, SFM wasn’t profitable, and WFM had a PE ratio of 36.1. Some will say that the companies with the best valuations outperformed, but this wasn’t the case at the end of 2013 when both WFM and SFM were up almost 70%.
Comparing The Current To Past Prices
It’s not uncommon to see comments and headlines like “it can’t go much lower from here” from the various financial news outlets. In certain cases, this is true as a stock can soon go from overbought to oversold, but the comparison with past prices isn’t the best way to go for investing.
A good example of how past prices don’t mean all that much is Tesla (Nasdaq: TSLA). The current price isn’t that far away from where it was in 2013, but in the meantime it has had one 47% decline and four declines between 20% and 40%.
Figure 4: TSLA 5-year stock price. Source: Yahoo Finance.
As TSLA has always moved around this level of $190, many see it as a benchmark where buying below this level is an opportunity and investors sell when the stock is above this level. If this is your tactic, you should know that the stock market is random, meaning that past price movements don’t influence future price movements.
The big lesson of this article is that if you don’t have the time or will to really dig into a stock—and by dig I mean analyzing 10-years of past annual reports, reading all the conference call transcripts you can get your hands on, have a very high understanding of the market the company operates in, understand the competitors, have a clear investment risk reward case made in relation to your portfolio—you shouldn’t be investing in individual stocks and at current market valuations, not even in mutual funds.
On the other hand, if you invest in stocks even with limited knowledge, then you should invest only money that you can afford to lose and consider it as tuition for future, more fruitful investing.