I must get the email about once a day.
How dare you say that about _________?! (Pick one: Taser, Ipix, Sirius Satellite Radio, AltairNanotechnologies.)
Don't you realize that _________ (stun guns, security cameras, satellite broadcasts, nanotechnologies) are the next big thing?
How I usually respond: "Uh-huh. Good luck with that."
What I usually leave unsaid: "You're going to need it."
It's not that I don't enjoy investing in companies with the capacity for monstrous growth. I do. But I keep these holdings small, because too much can go wrong with the next big thing. Finding it, and paying the right price, is far more difficult than anyone lets on. Here's why.
The next big thing may not be big, or next, or even much of a thing. For every Dell (NASDAQ:DELL) out there, there are dozens, if not hundreds, of wannabes that crashed and burned. How do you tell them apart? It's not easy. If there's such a thing as a superior crystal ball, I haven't seen it. I certainly don't have one myself, and I'm willing to bet most of you don't either. Anyone remember Iridium? The satellite phone biz seemed like a great idea to me and to plenty of happy investors. Who wouldn't want a phone that worked anywhere? It turned out that most people didn't. Oops. By 1999, Iridium was toast, taking billions of dollars down the drain.
You'll probably be late to the party anyway. When the next big thing's CEO is on the cover of the magazines and the guy washing your car is telling you to buy the stock, it's probably too late. Consider the hype at Apple (NASDAQ:AAPL). Steve Jobs has long been a magazine-cover darling, and as iPod sales have exploded over the past year, the buzz around the company has intensified. The real pyrotechnics, however, have been with Apple's shares, which in two years have nearly quadrupled to $40. They're wickedly overpriced. Why would I say that? Because ...
... the next big thing is always overpriced. You know why? Because it's the next big thing! Everybody wants it! No matter what you pay now, the story goes, it will seem cheap in retrospect because the next big thing will grow so quickly and become so huge. The trouble is that attitude can get your portfolio killed. Do we need to talk about America Online, now owned by Time Warner (NYSE:TWX)? In the starry-eyed days of the '90s, AOL's service seemed like a paradise. Surely people would keep clamoring to dial into its exclusive little world. Wow, AOL was growing at manic rates! Gimme that market order. It'll look cheap later. Really? If AOL hadn't bought Time Warner with its exceptionally overpriced shares, an independent AOL would be barely clinging to life; it's crippled now even as a Time Warner unit.
The next big thing might not make any money, even if it's "successful." What do I mean? There are companies out there that achieve a great measure of success in the marketplace but rarely scrape together a dime to repay shareholders. Martha Stewart Living Omnimedia (NYSE:MSO) is one. TiVo is an even better example. Everyone likes TiVo, right? Well, everyone except those who've held the stock since day one. What happens when the realization finally hits that the next big thing isn't making money? The shareholders share the losses. And those can be steep. The long-term TiVo chart is an abject lesson in the harsh realities of faith in the next big thing.
I've no doubt nanotechnology will reshape many industries. But is Nanogen (NASDAQ:NGEN) therefore a good investment? I doubt it. Will it make money? Still up in the air, and a long way off if it happens.
The sickness
Why do people make these kinds of mistakes over and again? Greed may be a part. Everyone likes money, right? But I think it's more than that. My guess for the real reason is this: hubris. Everyone loves to think he knows more than the next guy. Everyone loves to think he's in front of the curve. And the trouble with that pride is this: It don't goeth before a fall. In the stock market, pride leadeth directly to the fall. If you're smart, it will go afterward.
The cure
Here's a modest proposal, one we espouse at the Motley Fool Inside Value newsletter. Toss the pride. Admit your limitations. Concentrate on the obvious. And limit your risk.
I have no faith that I can see the future better than anyone else. But there's a secret Wall Street won't tell you: You don't need to. You won't need to because you're going to concentrate on obvious stuff that you can actually measure, like free cash flow, market position, and price.
Take McDonald's (NYSE:MCD) from mid-2002 until March 2003. It fought a brutal burger war with Wendy's and Burger King, and there were questions about its strategic direction. It was a wounded giant -- and its share price reflected that -- but one that had a great balance sheet, sported a world-beating market share, and continued to produce massive amounts of cash. Those who bought at the bottom, in March 2003, didn't need to see the future, or predict when McDonald's would go back up. They only knew that the odds were huge that it would. And it did, tripling in just over two years. There's a similar situation brewing with Inside Value pick Colgate-Palmolive (NYSE:CL). Its shares tumbled in September, after the company warned that earnings would fall short of estimates. Unnerved analysts fled for cover. I wasn't fooled. Colgate had only suffered a minor setback, but its shares dropped to big time value territory. I bought the stock and later sold for a nice profit.
The best part about both McDonald's and Colgate is that the downside risk was limited because everyone already expected the worst and had bid the stock down accordingly. It was limited because these firms are stellar performers. It was limited because they reward shareholders with dividends and stock buybacks.
The Foolish bottom line
If you're interested in repeatable, time-tested methods for market-beating returns, stop looking for the world-beater of tomorrow. Instead, look for the obvious thing right under your nose. Anyone who's followed the stock market for even a brief period knows that it's a fickle beast at best, and an absolute psychotic most of the time. Paying bargain prices for top-notch companies is the best way to build wealth over time, and better yet, it helps you avoid those stomach-churning screamers that can turn the next big thing into the next big joke. That's what Inside Value is all about.
Click here to try a free 30-day trial and have lead analyst Philip Durell guide you along this path. Or, even better, subscribe and get a copy of The Motley Fool's first-of-its-kind Blue-Chip Report 2005: 10 Monster Stocks for the Next Decade right now -- for free. Click here to learn more.
For related Foolishness:
- There's no trick. It's simple: Buy when the Street won't.
- There's a method to finding dirt-cheap dream stocks.
- Learn how to find relentless growers.
This article was first published on May 19, 2005. It has been updated.
Seth Jayson likes growth, but he'll take a lead-pipe cinch on a stable cash-maker any day of the week. At the time of publication, he didn't have a financial position in any company mentioned. Taser is a recommendation of Motley Fool Rule Breakers, and Dell and Time Warner are picks of Motley Fool Stock Advisor. View Seth's stock holdings and Fool profilehere. Fool rules arehere.
