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We have been covering a number of topics about what types of stocks to find and various ways to find them. This month we turn our focus on what stocks not to buy.
If I could avoid a single stock, it would be the hottest stock in the hottest industry, the one that gets the most favorable publicity, the one that every investor hears about in the car pool or on the commuter train and succumbing to the social pressure, often buys.
Hot stocks can go up fast, usually out of sight of any of the known landmarks of value, but since there's nothing but hope and thin air to support them, they fall just as quickly. If you are not clever at selling hot stocks (and the fact that you've bought them is a cue that you won't be), you'll soon see your profits turn into losses, because when the price falls, it's not going to fall slowly, not is it likely to stop at the level where you jumpers on. Look at Home Shopping Network, a hot stock in the hot teleshop industry, which in 16 months went from $3 to $47 back to $3.5 (adjusted for splits). That was traffic for the people who said good-bys at $47, but what about the people who said hello at $47, when the stock was at its hottest? Where were the earnings, the profits, the future prospects? This investment had all the underlying security of a roulette spin.
The balance sheet was deteriorating rapidly (the company was taking on debt to buy television stations), there were problems with the telephones, the competitors had begun to appear. How many zirconium necklaces can people wear?
Recall some of the hot industries where sizzle led to fizzle. Mobile homes, digital watches, and health maintenance organizations were all hot industries where fervent expectations put a fog on the arithmetic. Just when the analysts predict double-digit growth rates forever, the industry goes into a decline.
If you had to live off the profits from investing in the hottest stocks in each successive hot industry, soon you'd be on welfare.
There couldn't have been a hotter industry than carpets. As I was growing up, every housewife in America wanted wall-to-wall carpeting. Somebody invented a new tufting process that drastically reduced the amount of fiber that went into a rug, and somebody else automated the looms, and the prices dropped fro $28 a yard to $4 a yard. The newly affordable rugs were laid down in schools, offices, airports, and in millions of track homes in all the nation's suburbs.
Wood floors were once cheaper than carpets, but now carpets were cheaper, so upper classes switched from carpets to wood floor and the masses switch from wood floors to carpets. Carpets sales rose dramatically, and the five or six producers were earning more money than they knew how to spend, and growing at an astonishing pace. That's when the analysts started telling the stockbrokers that the carpet boom would last forever, and the brokers told their clients, and the clients bought the carpet stocks. At the same time, the five or six major producers were joined by two hundred new competitors, and they all fought for customers by dropping their prices, and nobody made another dime in the carpet business.
High growth and hot industries attract a very smart crowd that wants to get into the business. Entrepreneurs and venture capitalist stay awake nights trying to figure out how to get into the act as quickly as possible. If you have a can't-fail idea but no way of protecting in with a patent or a niche, as soon as you succeed, you'll be warding off the imitators. In business, imitators is the sincerest form of battery.
This is primarily sourced from Peter Lynch’s book entitled “One up on Wall Street” published in 1989.
Knowing what stocks not to buy is as important as knowing what stocks to buy. Knowledge in picking stocks is key to making above average returns. Contact us today, to learn more about how we find undervalued stocks.
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