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The Best Interest » Good Company, Bad Stock

Good Company, Bad Stock


I started working with a client a couple years ago whose incoming portfolio was 20% Starbucks. That’s a lat(te) in one stock. I’ll see myself out

ugh…

For comparison, Starbucks comprises 0.20% of the S&P 500. The S&P 500 should only be a portion of an individual’s stock holdings, which are only a portion of an overall portfolio (with bonds, alternatives, real estate, whatever). 20% is way too much Starbucks. 

When I started explaining this thought process, the client protested. “Jesse – there’s a Starbucks on every corner in America. Why would we sell it?”

This logic is very understandable. After all, there is a Starbucks on every corner in America. The premise is true. But this client’s conclusion—“Therefore, why sell Starbucks?!”—doesn’t follow his premise.

That’s the logical misstep we’ll dive into today. A “good company” doesn’t always make a “good investment.” 

Lessons from History

My hometown pride, Kodak, was once one of the most visible companies in the world.

It would have been easy to sit there in 1985 and think,

“Kodak is everywhere. They own the global film market the same way GE owns consumer electronics and Sears owns department stores. Why would I ever diversify out of Kodak?”

A seemingly logical investor

Well…

That’s a share price going from ~$90 per share to zero in about 17 years. The stock market and economic history are littered with “good companies” going broke. It’s called “creative destruction” and is an essential part of a healthy economy.

But it’s terrible if you happen to own those specific stocks.

It’s Not About Popularity or Frequency

Investor Peter Lynch is known for many quips, perhaps none more famous than:

“Invest in what you know. Know what you own and know why you own it.”

Unfortunately, many investors interpret that quote as:

“Invest in what you’ve heard of, and own it because you’ve heard of it.”

…and what they’ve heard of, naturally, are popular consumer brands and companies with a “high frequency” in society e.g. those with many stores, many products, long histories, etc.

But what Lynch actually meant in his quote is: “The more familiar you are with a company, and the better you understand its business and competitive environment, the better your chances of finding a good ‘story’ that will actually come true.”

You can’t just “know” Starbucks because you enjoy its coffee or because you see it on every corner. You must “know” its business fundamentals, competitors, potential future paths, etc. The market does not care about popularity or frequency alone. It only cares about popularity and frequency insofar as those factors positively or negatively affect the objective fundamentals of the business.

Past vs. Future

Riffing off the previous stanza, concepts like “popularity” and “frequency” are both hallmarks of a company’s past. The stores you see, the brand’s standing in our culture, and the company’s heretofore investment returns are all a function of what the company has done in the past.

But the stock market is forward-looking. The thousands of investors who buy and sell stocks and determine their daily prices don’t care about the past. They are, quite literally, trying to predict a company’s future. They are pricing in that anticipated future into today’s fair value.

Quite understandably, most investors don’t do this. They either shape their opinions based on the past (popularity, frequency, past investment returns, etc.) or they react to current-day news. These are both mistakes.

photo of person holding crystal ball

The intelligent investor thinks about the future. But any statement akin to, “Company ABC will be great in the future,” is a challenging statement to make accurately.

Wonderful Company? Fair Price?

Nothing against Peter Lynch, but most of you know I’m a fan of Uncle Warren, who is famous for saying:

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

Even if Starbucks is one of Buffett’s “wonderful companies,” is it trading at a “fair price”? Most people – including many investment professionals – are terrible at determining what a “fair price” truly is. Price is a defining feature of any investment!

I frequently use the “Honda Civic” example to explain this idea.

Is a Honda Civic a fair car? Sure. A good to great car? Quite possibly! Would you be happy owning a new Honda Civic? Many of you would say, “Sure, why not?”

But would you pay $100,000 for that new Honda Civic? No way.

It’s not enough to say, “Starbucks is a good company. Perhaps a great company.” That’s challenging enough on its own. But we must go further and ask ourselves if Starbucks is trading for a “fair price.” And quite simply, most of us are terrible at determining what “fair price” truly means – at least when it comes to stocks.

Needles

I’m biased, but I’m a big fan of this article I wrote in May 2023. I won’t rehash it too much here, but I encourage you to read it right now.

In short:
  • Most stocks perform worse than simple Treasury bonds
  • Only ~4% of stocks (or 1 in 25) account for all historical stock market outperformance over bonds
  • Anytime your odds are 1 in 25, you should think hard about your actions.

Sizing and Allocation

Play along with me. Let’s assume, for the sake of argument, the client was correct. Because Starbucks is everywhere, it must be a good stock to own, and it’s trading at a good price.

If that’s true, does it necessitate Starbucks should comprise 20% of our portfolio? Put another way: are there only ~5 good companies in America? 

Any way you cut the biscotti, a 20% position is severely overweight. In financial planning, we want to reduce our range of potential outcomes. That’s why we diversify. Having 20% of your money tied to one single stock leads to a wide range of potential outcomes.

Closing the Cafe

For what it’s worth, the client did listen to our counsel and has been divesting out of Starbucks (as tax efficiently as possible). This past week’s ~17% drop in Starbucks’ stock price hurts, but not as much as it would have two years ago.

I’m sure there are more reasons not to own a few single stocks, not to own Starbucks specifically, and not to have too many eggs in any basket. What do you think? If I’ve missed some low-hanging fruit (salad) in terms of my reasoning, please leave me a Comment below!

Thank you for reading! If you enjoyed this article, join 8000+ subscribers who read my 2-minute weekly email, where I send you links to the smartest financial content I find online every week.

-Jesse

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