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Good Company / Bad Investment
October 2020

Oct 30, 2020 | Business Owners | Families | Featured

It’s often easy to determine when a company is poised for a strong period of revenue and earnings growth. However, even if the future for a particular issue looks rosy from a business perspective, a good investment opportunity may not be present. It turns out that the price one pays for a security is as, if not more, important than future earnings growth. This leads to the “good company, bad stock” phenomenon. A good example of this is famed biotechnology company Biogen. Back in 2000, Biogen was perfectly positioned at the forefront of the emerging field of biotechnology. Their sales and earnings growth forecast were robust. Over the next 10 years, Biogen’s rate of earnings growth was in fact realized, coming in at a thundering 280%. Yet during this same ten-year period, their stock price averaged a paltry annual growth of 1.3%. In this case the investors in the stock got the earnings growth they were looking for but did not make any money on their investment. The reason was rooted in what they paid for the stock back in 2000. Hindsight shows they paid too much. The lesson for investors is that a good business purchased for too high a price can become a bad investment. This paradigm applies not only to stocks but to industries, sectors, regions, and even markets as a whole. The opposite of this analysis can also be true, where a mediocre or even poor business idea can turn into a good investment if it is purchased cheaply enough. The key is to look at the current relationship between a security’s earnings and its price. Over longer periods of time this relationship can become quite visible. Yet in any short-term period, the relationship can dislocate significantly in either direction, largely do variation in investor enthusiasm or sentiment. So be sure to include the question of “at what price?” when considering the potential of any investment. Failure to consider price in your fundamental analysis of an investment can leave you feeling victorious for seeing the business growth you anticipated but having nothing additional in your pocket for being right.

 

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