Transcript:

Austin Smith: Morgan, you made a point in an article recently that a great company doesn't always make a great investment. That's a difficult thing for people to understand because we always say, "Buy great companies," but of course you have to buy them at the right price.

So, I'm wondering if you could shed a little bit of light and provide some clarity on that distinction.

Morgan Housel: You just said the point yourself. It's great to buy good companies. You always want to do that, but you have to get them at the right price.

Two examples that I like to use to show why a great company doesn't always make a great investment are Microsoft (NASDAQ:MSFT) in 2000 and Wal-Mart (NYSE:WMT) in 2000.

Austin: Right.

Morgan: From 2000 to, let's say 2010, Microsoft earnings did very well. Their earnings just about tripled, their revenue doubled, they really increased their dividend, they had some smart share buybacks. Microsoft, the company, did really well.

What happened to its stock? It fell about 60%.

Austin: Right.

Morgan: Why was that? It's because in 2000 it was just dramatically overvalued.

Austin: Right.

Morgan: So even though the company was performing very well, the stock returns were miserable.

It's the same thing with Wal-Mart. From 2000 to 2010, Wal-Mart the company did very well. You had really strong earnings growth, you had good strong dividends, really smart buybacks. What happened to the stock? It fell 50%.

Austin: Right.

Morgan: That too, if you go back to 2000, why did that happen? It's because Wal-Mart was just grossly overvalued in 2000.

To me, that's a really strong lesson -- that great companies at the wrong price are still going to undermine the investment thesis.

Austin: I take two very important takeaways from that. One, I look at a company like Amazon (NASDAQ:AMZN), a company that... there are a lot of Fools around the office who are very bullish on it, there are some who are bearish; it's a contentious company.

Personally, I just don't like the valuation. They're a tremendous company. I admire everything about them, but I just don't like the price that I'm paying for that company. I think you may see a similar situation to a Microsoft and a Wal-Mart, a decade out, where the company continues to grow but your share price just doesn't appreciate that much.

Morgan: You're paying so much for it that, when the company does grow, you're just not receiving that benefit through the shares.

Austin: Right, and now a flip side of that that I think a lot of people have missed right now is Apple (NASDAQ:AAPL). This is a company that, everybody looks at what happened to Microsoft and they say, "Well, it was a bad investment, and Apple is where Microsoft was in 2000."

The difference is that Microsoft was trading for about 70 times earnings in 2000. Apple's trading for about 12.

Morgan: Yeah, it's a very different situation there.

Austin: Right. A lot of people look at one situation and they overlay it without looking at the dynamics. Apple's trading for a very cheap valuation today, so Apple's an example of a great company at a great price. Microsoft in 2000 was a great company at the wrong price, and it makes all the difference.

Morgan: Exactly. Right.

Austin: OK, well I hope that helps clarify the point, the difference between a great company and a great investment. Fools, thanks for watching!

Austin Smith owns shares of Apple. Fool contributor Morgan Housel owns shares of Wal-Mart Stores. The Motley Fool owns shares of Apple, Amazon.com, and Microsoft. Motley Fool newsletter services recommend Apple, Amazon.com, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.