"Good" company versus good stock investment

One of the most difficult concepts to grasp in all investing is the difference between a "good" company and a good stock investment.

The intuitive take most people have is that a "good" company is a good stock investment. Seems to make sense, doesn't it?

But, this is rarely the case. Why? Because a company's stock price reflects how people in general think of it.

If everyone loves a company and buys its stock, then its stock price will rise to meet that growing demand. Popular stocks have high prices relative to their underlying value.

"Good" companies, as recognized by the vast majority of people, tend to be over-priced.

The opposite is true for "bad" companies. When the vast majority of people think a company is garbage, its stock price reflects that lack of demand. Unpopular companies tend to have low prices relative to fundamentals.

"Bad" companies, as recognized by most people, tend to be under-priced.

This is very counter-intuitive for most people and a bit hard to handle. It doesn't seem to make sense to buy something everyone hates and sell something everyone loves. After all, can the majority be consistently wrong?

Yes. The proof of the pudding is in the eating, and when you buy "bad" companies and sell "good" companies, you get better returns than if you sell "bad" companies and buy "good" companies. The statistical studies on this are too numerous to detail here, but the solid weight of statistical and anecdotal study is that "bad" companies' stocks out-perform "good" companies' stocks.

You can implement this strategy in a non-concentrated way by simply buying the hated and selling the loved. I recommend high diversification for this approach because some of those "bad" companies will actually turn out to be bad and some of those "good" companies will turn out to be good investments. You need the benefit of a large number of investments to get everything to average out and get good results.

Another approach, that I believe generates better results, is to work hard to figure out which companies are good and perceived "bad."

As you may have noticed, I've been using quotation marks around "good" and "bad" to indicate good or bad as seen by the majority. But, the majority isn't always right. Sometimes a "bad" company is a very good investment because it is actually good and everyone perceives it to be bad. Then, not only do you have the long run tailwind of a good company's underlying fundamentals that time will make clear, but you also get to buy it at a "bad" company discount to underlying value. Then, you can get some truly phenomenal long term investing results.

This is the approach that I use. I buy companies everyone seems to hate where I believe the crowd is wrong.

It's tough to implement this approach, though, because when you tell people what you're buying, they look at you like you're crazy (frequently a sure sign of good investment). It's hard to be on the extreme minority side of opinion, and with investments people can be very passionate about their views (people like to tell you how stupid you are and all the things you aren't paying attention to). Sometimes, the majority turns out to be right and you end up looking and feeling like a fool. That's the price you pay to get outstanding results, though, and it's well worth it.

Remember, a "good" company isn't necessarily a good investment. Knowing the difference can mean the difference between good and bad investing results.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.