As every investor knows, advice is cheap. Anyone who's traded a month's wages for a few shares in a promising company has a theory they'd gladly bend your ear over. There are dozens of different approaches to making money in the market, each one with enough reading material to fill up an entire episode of Hoarders.
While a sound thesis is vital for success in the market, individual investors should be just as aware of the red herrings that are too often advanced by pundits and analysts. Realizing when a stock makes a bogus move can be just as valuable as knowing when a breakout is warranted. Here are two of the most insidious false idols.
Comparing P/Es within an industry
Rejecting a stock because it's valued at a premium to its industry is kind of like saying to an NFL owner: "Why would you pay so much for Tom Brady when you could get Rex Grossman for much cheaper? They're both quarterbacks." If your objective is simply to hire someone to take snaps, then Rex Grossman should suffice. But if you want to actually win games, Tom Brady's probably a better bet.
The same holds true in investing. Commentators love to remark how such-and-such a stock is overvalued compared to its industry. The problem with this approach is that the P/E ratio is a measure of what investors are willing to pay for future cash flows. The brighter their future, the greater the P/E will be. Comparisons to other companies within the industry are therefore irrelevant. While some industries may be growing faster as a whole than others, a promising growth company can be found in almost any sector and nearly every industry has a few bright upstarts as well as a handful of old maids.
For example, Chipotle (NYSE: CMG ) trades at a price-to-earnings ratio of 57 -- a steep multiple to be sure. Analysts often complain that the burrito chain is overvalued compared to other restaurant stocks, and a look at other large-cap restaurant stocks shows their multiples to be much lower. McDonald's trades at a ratio of 19, while Yum! Brands carries a P/E of 24 and Starbucks sports a 29.
But taking this strategy to its natural end would lead an investor to look for the lowest P/Es they could find in a given industry. For instance, Darden Restaurants is a dividend payer with a P/E of just 15. That company, however, actually reported a 24% decline in earnings per share in its latest quarter. Clearly, the parent of Olive Garden is headed in a different direction than Chipotle, which continues to expand and boost same-store sales. After looking at their valuations from that angle, the cause for their disparity becomes obvious. Chipotle trades for a higher multiple than its peers because its growth opportunities are much greater.
Figures like operating margin or inventory turnover can be useful when comparing industry competitors, but for P/E ratios, you're better off choosing a stock with a similar P/E ratio. In Chipotle's case, I'd consider using lululemon athletica, Intuitive Surgical, or even Amazon.com as a gauge.
Pegging one company's share price to another's
Every company has a unique set of circumstances underlying its prospects, but to better understand them, investors like to draw analogies and apply certain factors that affect one stock to another. This technique is perfectly useful when assessing an issue like commodity costs, which should affect a group of competitors in a given industry similarly. However, investors can get carried away with these comparisons, and often use them mistakenly.
As my colleague Rick Munarriz describes, the market has tossed Green Mountain Coffee Roasters (Nasdaq: GMCR ) through all kinds of muck and mire and dragged fellow beverage server SodaStream (Nasdaq: SODA ) with it. Though the two companies compete in the beverage industry and both employ a razor-and-blade business model, their stocks should not be trading in tandem.
Green Mountain's collapse at the end of last year kept SodaStream trading at a surprisingly low price despite the carbonated-drink maker's strong third-quarter earnings report. The argument that Green Mountain was losing valuable patents and using faulty accounting methods simply did not apply to SodaStream. Similarly, when Green Mountain shot up 24% earlier this month on strong earnings, SodaStream followed, climbing nearly 4%. Again, there was no good reason for SodaStream to jump -- it was just a free pass from the market.
Likewise, tech stocks often trade in line with each other. Amazon reached a record high last October on a strong earnings report from Google, but the stock then slid when Apple's (Nasdaq: AAPL ) quarterly results underwhelmed, and Amazon finally crashed when it reported its own earnings.
The market seems to believe these companies should track together because they are fighting each other for dominance in a number of evolving tech industries. Though analysts like to mention them in the same breath, they are actually much different companies -- as you can obviously tell from their revenue streams. Apple makes high-priced gadgets like smartphones and tablets. Google, despite its attempts to diversify, is essentially the world's foremost search engine. Amazon is synonymous with online retail. You can compare them all you want, but they're subject to vastly different market forces.
Unjustified stock moves present some of the best buying and selling opportunities for investors. When you see a stock getting beat up due to a comparison with its peers, question the merit of the argument against it. Oftentimes, the logic is flawed, and that's when the savviest investors look to buy. In fact, our expert stock pickers at the Fool have found one such industry that's recently taken an undeserved hit, and even Warren Buffett has noticed. "It clearly doesn't make sense," he said. "If I had the choice of buying or selling these companies I would certainly be buying." Find out what these undervalued companies are in the Fool's latest free report: "The Stocks Only the Smartest Investors Are Buying." Just click right here to get your free copy.