A .299 average ... 40 home runs ... 119 RBIs.
Those are the three-year average stats of superstar New York Yankees third baseman Alex Rodriguez, or "A-Rod" as he is more commonly called. In addition to these terrific numbers, he's been a perennial All-Star and has won 2 MVP awards to boot. Not too shabby, eh?
Yet since joining the "Evil Empire" in 2004, no athlete -- in any sport -- has received more criticism from fans, the media, and even other players than Mr. Natural himself. How could this be? Well, while A-Rod is widely regarded as the most talented player in the game, he gets paid like it, too. And the old maxim "To whom much is given, much is expected" obviously holds on the baseball diamond as much as it does everywhere else.
In 2004, A-Rod made the move to New York along with the bulk end of his 10-year, quarter-billion-dollar contract. A contract of that magnitude carries an entirely different level of expectations -- the stratospheric kind. Yet A-Rod has a total of zero World Series rings with the Yanks, or any other team for that matter. And though his numbers are definitely among the league's top tier, they're simply not the best. Unless A-Rod carries the Yankees to a World Series championship this fall, he'll continue to be considered a huge disappointment.
Is all of this unfair? Maybe. But again, it's the same in baseball as in all other walks of life -- even the stock market.
Paying up for performance
Pay up for a stock that Mr. Market has lofty expectations for, and you might be putting yourself in a dangerously precarious position, even if the company delivers an All-Star-caliber performance.
Sure, any Fool would want A-Rod or David Ortiz batting cleanup for his or her interoffice softball team. Likewise, anyone in his or her right mind would love to own the most profitable, fastest-growing companies. Superstar names like digital-music MVP Apple
Price does matter in investing, and when price is thrown into the equation, things aren't so equal anymore. This is where it gets a little tricky. Wall Street loves growth, consistency, and high degrees of certainty more than anything else -- and who wouldn't? Theproblem is that investors love these situations so much that shares are often bid up to dangerous price levels just to "get in" while the going's good.
Beware of motion sickness
For example, Research In Motion is now trading at a price multiple of more than 50 after last week's earnings report and subsequent 20% run-up in its shares. At current prices, a quick-and-dirty discounted-cash-flow check indicates to me that to earn an annual 10% return by holding on to RIMM shares over the next five years, the company would need to grow its free cash flow close to a whopping 40% in each of those years. Possible? Of course. Anything's possible. Probable? Well, all I know is that I wouldn't bet it, especially in such a rapidly changing business like mobile communications.
Eventually, the laws of finance will grab hold, and at a certain price level, any advantage of holding a superstar asset will be rendered useless. At even higher levels, the asset will actually begin to earn negative returns for investors. At that point, it should be regarded as a liability.
At this price, you can go wrong
So what's an alternative to paying up for fast-growing companies? Be reasonable. Heck, go ahead and be cheap.
When investigating a stock, it's crucial to figure out exactly what you're paying for. Ask yourself: What are the risks involved? What is a fair return for being exposed to these risks? What kind of growth rate needs to be sustained for me to earn this return? And given the competitive landscape, future demand, and management's ability, are these assumptions reasonable? Then, compare your stock's risk/reward characteristics with market alternatives. You want to be sure you're getting the biggest "home run" bang out of your limited investment buck.
Eagles or Googles?
To illustrate, take a look at this overly simplified choice between two stocks.
Let's say at the beginning of 2006, you were looking to purchase a single stock with your hard-earned Christmas bonus. In January '06, Internet search giant Google
Well, if you'd chosen Google shares -- the stock with the highest fan support, growth rate, and cheeriest consensus at the time -- you would be down about 10% right now. However, if you'd bought American Eagle stock instead -- which, at the time, was batting miserably and being assaulted with jeers and boos from analysts -- you'd be up almost 100% today. What could possibly account for such a wide discrepancy in returns? Again, it's the expectations.
Expect the worst; hope for the best
In general terms, Google shares had astronomical growth assumptions baked into its price. The instant Google reported earnings that came in under the old expectations bar, the stock plummeted off its highs and has yet to return to its January levels. In other words, Google shares had A-Rod-like expectations written all over them.
On the other hand, American Eagle shares were being priced with uncommonly poor growth expectations, given the company's strong track record and operating history. Once American Eagle reported numbers that even slightly indicated that these lowly forecasts were unwarranted, its shares left the building and haven't come back down since.
Question your assumptions
Of course, this is a basic explanation, and we'd need to take a closer look at the fundamental drivers to understand why these companies reported the results they did. The point, though, is that by taking the time to ask some constructive questions, you force yourself to consider the specific assumptions implied in the stock's purchase price.
You might just find that the stock you're attracted to -- even if it has some of the prettiest-looking stats in the league -- might actually have a tough time living up to the expectations of the manic, obsessive, and overly critical fans over on Wall Street.
For related Foolishness, see "Great Company, Lousy Investment."
Starbucks is a Motley Fool Stock Advisor recommendation.
Fool contributor Brian Pacampara owns shares of American Eagle. If you're like the frugal, penny-pinching general managers over at Inside Value, give the newsletter service a try free for 30 days. They'll come up with stocks that resemble Joe Mauer and Freddy Sanchez, who each won batting titles this year but get paid less than $400,000 for their efforts. Talk about some great bargains. Alex who? The Fool's disclosure policy is always a major-league performer.
