Friday, August 3, 2012

The Fundamentals of Investments

The most insane piece of investment advice I've ever heard was relayed by a friend who was taking an investments class at the local adult school. The instructor's key to investments and stock selection was to pick the stock of solid companies with which you dealt and trusted. The insane part of this advice is that it totally ignores valuation. Yes, Google may be a great company, but before you buy it shouldn't you ask whether it's currently selling for $50 a share or $1,000? And even if it's a good idea to buy stock in "good" companies, wouldn't it make sense that the current price already reflects the value that you have perceived?

Now this is not to say that people haven't made a lot of money in some stocks using this approach. and indeed this approach is so common to have a name--fundamental analysis. For example, fanatics of Apple products who backed up their product devotion with a financial investment have done well. On the other hand you could have paid $644 for Apple stock a few weeks ago and be down $27 a share. After all, no stock always trades at an all time high. And what about the devoted followers of Blackberry, or Palm Pilot or the Windows operating system or Farmville? You
would have lost big bucks if you backed up your fundamental analysis with cash.

Generally speaking, a stock's current price reflects what the investing public knows and expects about a company. (The term "investing public" does not refer to the man-on-the street public, but rather professional investors, and what you or I think about a stock's valuation doesn't matter.) Subsequent changes in value reflect how revised knowledge and expectations differ from the past. I'd say that many investors have owned Apple stock at some point in time in the past, but when their primary product was the MacIntosh computer, and it seemed to be losing ground to Windows based computers such that it would become extinct, a lot of people bailed out. Like me.

With all this in mind, it turns out that the recent public offering of Facebook capsulizes this discussion very well. There was a frenzy in the IPO as public demand under the fundamentalist approach (plus greed on the part of the issuer) sent the offering price way above the original expectation. While there was pro forma financial information issued, since Facebook had not been publicly traded there wasn't the history of company commentary and investment adviser analysis to determine if the $38 IPO price was realistic or not. As post-IPO trading first showed, and the first public quarterly earnings release emphasized, it was not by a long shot.

On the other hand, since future stock price movements are caused by subsequent changes in facts and expectations, who's to say that despite the negative fundamental news about Facebook that its current price of $20 might be an undervaluation? Only time will tell whether this fundamentally unsound stock is now actually a good buy.

And since I've brought up the subject of Facebook, I'll close with another dig at the way the state of California balanced its budget for the fiscal year that just started. It projected $1.8 billion in revenue from taxes paid by original Facebook shareholders who could monetize their investments once the company went public. At a sales price of $38 per share, that might have been a realistic number. But due to the lock up period, those insiders were not immediately permitted to sell their shares, and will have to wait until the upcoming weeks and months. So at $20 per share, the actual California budget deficit just got larger as California is not going to realize $1.8 billion. This also reinforces the underlying weakness of California's income tax system which disproportionately (much more than the federal government) relies on taxing the rich. While that strategy may work in good times, it's toxic when things don't go well since the income of wealthier taxpayers is much more adversely affected when times are bad, and makes forecasting revenues highly unpredictable.

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