Fool.com: A Visit to Los Angeles (Fool on the Hill) August 10, 1999

FOOL ON THE HILL
An Investment Opinion

A Visit to Los Angeles

By Warren Gump (TMF Gump)
August 10, 1999

This past weekend, I had a chance to go out to Los Angeles to represent the Fool at radio station KFI's listener appreciation day, Stimuland. It was a great opportunity to meet with thousands of people, some loyal Fools (hey, Dawn C.!) and others who have never given any thought to investing (why don't you start by reading the 13 Steps to investing Foolishly?) The entire experience was quite enjoyable.

When reflecting on the event, however, I couldn't help but think about the story of the financier who avoided losses in the 1929 crash because he sold all of his stock right before the tumble. You see, his shoeshine boy started to give the financier stock tips. The financier figured that if everyone was talking about the stock market, including even the shoeshine boy, that the market was most likely overvalued. He eliminated his equity exposure, enabling him to retain his wealth through the 1929 market plunge.

On my L.A. jaunt, I ran into people from all walks of life who were talking about (and investing in) the stock market. Not just the high-powered professionals who are "supposed" to be investing, but everyday Americans, including retirees, artists, nurses, writers, and bellmen. I didn't meet all of these people at our Stimuland booth, where finance was an obvious topic. Some of the conversations started on the Street, when people saw me wearing a Motley Fool T-shirt. Does the fact that everyone seems interested in the market signal an impending market crash?

I find the general hypothesis around that theory far-fetched. Having the majority of Americans invested in the equity markets seems to bode quite well for our (and the market's) future by providing sufficient capital for companies to fund continued growth. At the same time, those investors should reap the rewards of that growth, as higher earnings and cash flow justify improved stock prices. Seeing "everyone" in the market indicates to me that friends, the media, and financial planners have successfully spread the word that equities tend to be the best place to invest money for the long haul. I'm not scared at all by the fact that everyone wants to participate in the stock market.

I do, however, have some concerns about the way that many people are approaching investing in individual stocks. Instead of viewing their stock purchase as the acquisition of a sliver of a corporate enterprise, lots of people seem to view stock picking as a game where you don't have to learn about the companies you own. I've heard way too many stories about people jumping aboard an individual stock simply because its price has jumped rapidly over a short time frame.

These folks seem to think that if a stock did well over the past couple of weeks or months, it must be a great candidate for a further price leap. While such a company could be well-positioned for future growth, quite often a short-term, massive spike is indicative of investors temporarily becoming overly optimistic about some news event that won't have much impact on the company's future performance. (The most prolific of which is an upgrade by a Wall Street analyst, which has absolutely no impact on a company's business fundamentals.)

A couple of people actually came up to me at Stimuland and whispered into my ear the names of stocks that, according to their broker or a friend of a friend, are poised to become the next America Online (NYSE: AOL) or Microsoft (Nasdaq: MSFT). When I asked what exactly the companies did, both people told me they had no idea, but it was tied to the Internet. I fear that quite a few people are under the illusion that by randomly purchasing a company in a "hot" sector -- data infrastructure, software, the Internet, biotechnology -- without regard for corporate fundamentals will result in a several-fold increase in value over a short period of time.

Investors should never forget that the primary reason stocks have been successful investments throughout this century is because Corporate America has shown an impressive ability to increase earnings and cash flow. As these drivers of value improve, so does the net worth of their owners. This maxim also holds for individual companies. It should be noted, however, that this could be good or bad news, depending on how your company performs. Those firms that successfully and profitably adapt to competitive threats have been terrific performers, while many less-than-stellar companies have fallen by the wayside and possibly even into bankruptcy.

Before investing in individual companies, you need to be certain that you have the time and interest to learn about and track your companies to ensure that they remain positioned to increase their earnings and underlying net worth. While this task doesn't need to consume your life, it should at a minimum incorporate an understanding of the company's industry, its business model, major competitors, valuation, and financial structure. In addition, you should review the company's performance at least once a year (ideally quarterly) to ensure that it is still on track to achieve what you expected. This evaluation needs to be performed to ensure that your initial assessment was correct and your company is not headed toward oblivion.

If you don't have the time to perform this kind of due diligence, you will most likely be better served by lumping your money into a low-cost index mutual fund that tracks the U.S. markets. Such an investment allows you to benefit from the continued prosperity that most of us expect to see over the coming century, without subjecting yourself to the company-specific risk of owning uninvestigated individual stocks. Over the past few weeks, some people have started to feel the pain of not fully understanding and investigating individual stocks. In the months and years ahead, the pitfalls of such a strategy will become even more apparent.