When you own or like a particular company, you're more likely to get excited by any breathless article or blog post that sings its praises. But unless it backs up its praise with sound logic, even the most complimentary description of your most beloved stock could steer you wrong.
To understand why, consider one recent writeup I found. The author first explained that he really liked how earnings were shaping up in the medical supply industry. With many companies in the sector reporting strong profits, he reasoned that shares of one specific medical supply company would likely rise in advance of its upcoming earnings report.
Assuming that all companies in a given industry will behave similarly is a bad move. Drugstore chains CVS Caremark (NYSE: CVS) and Walgreen's (NYSE: WAG) profitable performance hasn't spared their rival Rite Aid (NYSE: RAD) from a troubled past and a deeply uncertain future.
Murky logic
The author then employed faulty psychology, arguing that just because other medical supply companies fared well, investors would expect great things from this particular company, and bid up its shares. Note that his call wasn't based on the company's actual health, business operations, or any other fundamentals -- just the author's hunch. Relying entirely on such gut feelings is more like gambling than investing.
Next, the author dismissed expectations that the company would post a substantial loss in its forthcoming quarter. Since other companies in the industry had reported sizable jumps in earnings per share, the author expected his chosen stock would follow suit. In short, he ignored the company's performance to focus entirely on that of its peers.
A business's competitors can sometimes offer hints to its own performance, but only if they occupy a relatively similar status within its industry. In this case, the author cited the performance of giants such as Medtronic (NYSE: MDT), St. Jude (NYSE: STJ), and Boston Scientific (NYSE: BSX). Unlike those healthy rivals, the company he discussed has a market cap of less than $100 million, and its stock price has fallen 90% in recent years, making his comparison seem more like wishful thinking.
Beta, shmeta
Another supposed plus for the company was its steep beta, indicating greater-than-expected volatility. The author believed this would allow investors to profit from big swings. But jumping in and out of any stock on a short-term basis does investors no favors. It's incredibly difficult to successfully time the market, and frequent trading exposes you to higher taxes and greater commission costs. For long-term investors, beta means little. A healthy, growing company can have very volatile stock, but as long as it grows over the long haul, investors should profit.
Finally, the author noted that the stock had fallen roughly two-thirds below its 52-week high. But such a steep plunge offers no guarantee that the stock won't keep falling, as AIG (NYSE: AIG) has amply proved.
Beware of short-term "sure things"
The day of the author's write-up, the stock in question did indeed jump. Alas, that high point didn't last. The company reported worse-than-expected earnings a couple of weeks later; shares have fallen sharply ever since the write-up came out.
Don't let faulty reasoning lure you into a short-term mind-set, Fools. Rather than gambling on the market's unpredictable moves in the next few weeks or months, look for companies that will dominate their peers for years to come. More importantly, make sure you judge a stock more by its own performance than that of its rivals.
Would you have followed this article's advice? Seen other examples of bad investing counsel? Tell us all about it in the comment box below.
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