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Driving Us Batty

Adam M. Grossman

WHAT DRIVES THE PRICE of individual company stocks, and why do some soar while others sink? It comes down to five factors, I believe.

The first two factors are a company’s observable strengths and weaknesses. Consider Apple. Its strengths are easily quantifiable. In the U.S., it’s captured more than half the smartphone market. When you take into account the company’s premium prices, it collects a disproportionate share of the industry’s revenue. Last year, Apple’s profits hit nearly $100 billion, making it the most valuable American company. Because of this, it would be easy to be bullish on Apple’s future, and thus on its stock.

You could make a similar observation about a company like Tesla. It holds about 50% of the U.S. electric car market and saw revenue grow by 51% last year. It also has a cult-like following. Chip maker Nvidia is in a similar position. Artificial intelligence (AI) services like ChatGPT run on its chips. As a result, in its most recent quarter, Nvidia’s revenue tripled and its profits grew 1,200%.

Against those strengths, investors weigh a company’s observable weaknesses. That’s the second variable that drives stock prices.

Let’s look at Apple again. The company is clearly on a roll, but does it have weaknesses? A key concern is market saturation. At some point, everyone who needs an iPhone, Mac or iPad will have one. Because of Apple’s premium pricing, consumers can be slow to upgrade. That’s one reason Apple’s revenue fell in its most recent quarter. In valuing Apple shares, an investor would want to weigh its immense profitability against this sign of potential weakness.

Tesla, too, is not flawless. While it holds half the electric car market, its market share was even higher before competitors came along. And because Tesla has lowered prices at the same time that it’s lost share, its financial picture isn’t as strong as it was even a year ago.

What about Nvidia? After gaining more than 1,200% over the past five years, many are wondering if the stock is riding on a knife’s edge. While its valuation doesn’t look unreasonable, with a price-to-earnings ratio of 25, that’s predicated on continued demand from AI developers. Because the market is so new, that’s not guaranteed.

These two factors—how investors weigh a company’s observable strengths and its weaknesses—are two key drivers of stock prices. But stock-picking would be a whole lot easier if those were the only variables. The reality is that share values are also driven by another set of strengths and weaknesses.

To understand these two drivers—our third and fourth—let’s continue with the above examples. If you wanted to calculate a valuation for Apple’s stock, you’d certainly start with all of the information—both positive and negative—that is publicly available. That’s what we discussed above. The problem, though, is that this would fail to capture what’s below the surface. What, for example, is Apple cooking up in its labs right now?

Of course, there’s the next generation of the iPhone, but it may also have something—or many things—entirely new. Because no one knows about them, their revenue isn’t reflected in Wall Street analysts’ valuation models, and thus those potential future profits aren’t reflected in Apple’s share price today. The same is true of Tesla, Nvidia and every other company.

At the same time, there are negative factors below the surface that should also factor into a company’s share price. Given its size, Apple could easily become the subject of an antitrust inquiry. And because most of its manufacturing is in China, it could get caught up in political tensions between Washington and Beijing. So far, CEO Tim Cook has done a great job managing this delicate relationship.

But what if Cook were to retire? It wouldn’t be unreasonable. He’s 63, has a net worth in the billions and has been on the job for 12 years. If he did, would his successor do as good a job? This same set of concerns could easily apply to the other companies we’ve looked at. Tesla and Nvidia could find their market-leading positions subject to regulatory scrutiny. Both are highly dependent on their skilled and highly visible CEOs.

Those aren’t the only potential weaknesses that could hurt share prices. Another worry, especially for technology companies, is the “two guys in a garage” risk. Apple, Microsoft, Google and HP all started that way. Michael Dell and Mark Zuckerberg started in dorm rooms before they even had garages. This is proof that an upstart competitor—armed only with a good idea and a shoestring budget—could upend an incumbent at any time.

To appreciate this, think back to the days before the iPhone was unveiled. BlackBerry was dominant, and now it’s essentially gone. A new competitor is a fundamental risk to any company’s share price, and yet it’s completely invisible to the public and it’s impossible to know how to factor it in.

To accurately value a stock, then, we need to take into account all of a company’s observable strengths and weaknesses, as well as those that are unobservable. That might seem hard enough, but there’s a fifth driver to consider: how investors interpret the data they have.

Consider the electric vehicle (EV) market. Toyota has discussed a new battery technology that it believes could double its vehicles’ range, and at a lower cost. This information is publicly available, and it could be damaging to Tesla and every other EV maker. But right now, it doesn’t seem to be affecting share prices. At some point, though, that might shift. When? No one knows. That’s why this fifth and final driver of share prices is perhaps the most difficult. It’s fully in the realm of psychology rather than anything that can be captured in a spreadsheet.

These five factors reveal an irony of investing. On the one hand, stock-picking is frustratingly difficult because of the unpredictable ways in which these factors come together. That’s why both professional and individual investors have a hard time beating the market. But at the same time, thanks to these same factors, stock-picking can be a lot of fun, as I can attest.

Earlier in my career, when I worked as a research analyst, I studied everything from computer storage to paper towels. Among other topics, I learned how Boeing constructed its Dreamliner and how GE built wind turbines. I had an excuse to follow each new iPhone release. And then, together with colleagues, we’d spend hours debating what we’d learned. As an intellectual game, it was a lot of fun, so I understand why—despite the discouraging data—stock-picking still has an appeal.

With the benefit of hindsight, stock-picking sometimes looks downright easy. Ten years ago, it was no secret that iPhones were great, that people enjoyed watching movies on Netflix, that Google’s search engine was popular, or that Amazon was getting quicker and quicker with deliveries. Looking back, it seems like it would have been easy and obvious for anyone to buy those stocks. That, fundamentally, is the challenge. Stock-picking, when it’s successful, looks fun and profitable, while index fund investing can feel a bit like eating your vegetables—good for you, but not very entertaining.

What’s the solution? As I’ve noted in the past, investing requires us to channel, simultaneously, five sometimes conflicting ways of thinking. In making decisions, we want to be part optimist, part pessimist, part analyst, part economist and part psychologist. If you can strike that balance, then you can, I think, successfully navigate this question—and find the answer that makes sense for you.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.

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