FREE NEWSLETTER
THE WAY INVESTORS think about the stock market may be entirely wrong.
Intuition tells us, and academic research confirms, that a company’s stock price should respond to important news and information. When a company announces a new product, for example, its stock should go up. And when results fall short of expectations, it should decline.
But a new paper titled “The Inefficient Pricing of News” calls this idea into question. The authors found that investors respond much more slowly and inconsistently to market news than previously thought. In some cases, it took a year or more for a stock price to respond.
Why would that be the case?
Tony Fadell is often referred to as “the father of the iPod.” For years, he worked side-by-side with Steve Jobs, first developing the iPod, then the iPhone. In a recent interview, Fadell shared details of what the product development process looked like inside Apple, and how the reality on the inside often differed from the way it appeared on the outside. Fadell’s comments can help us understand why stock prices often miss the mark.
The nature of competition. Investors, Fadell argued, often have a one-dimensional understanding of companies. As an example, he told the story of the development of the iPhone. When it was first released, many observers dismissed it as an overpriced toy. Unlike the BlackBerry, the dominant mobile device for corporate users at the time, the first iPhone lacked key security features and didn’t have a physical keyboard. As a result, it was perceived as a niche product with narrow appeal.
Fadell explained, though, that Apple looked at the market differently. Yes, BlackBerry had a very high market share among business users, but it had only a small share of the overall mobile phone market—just 1% or 2%. Apple was interested in the rest of the market: “What about the other 98% of the people? What would they want?” That was the question Apple was asking internally. Observers on the outside, though, underestimated the iPhone’s potential because they assumed they understood Apple’s competitive objectives.
The definition of success. Investors often make another mistake, Fadell said. They use the wrong yardstick in measuring successes and failures. He notes that early versions of both the iPod and the iPhone had significant shortcomings. The first iPod worked only with Apple computers. The first iPhone was underpowered and wasn’t open to outside app developers. The App Store didn’t debut until a year after the iPhone’s release.
For all these reasons, early critics continued to underestimate the iPhone’s potential even as it gained market share. But inside Apple, the potential was clear. They knew that all of the core components would get better each year and that cell phone networks would get faster.
Fadell, who also invented the Nest thermostat, made this observation: “Everything needs three generations. I’ve never seen anyone get it right the first time.” Wall Street, however, tends to not be that patient, and that can lead to a disconnect between perception and reality in stock prices.
Fadell notes that even when a product fails, it can be valuable. Apple learned a lot from the Newton, its first attempt at a mobile device. Similarly, Amazon had a short-lived mobile phone called the Fire. From the outside it was deemed a costly mistake, but Jeff Bezos saw it differently. “You can’t, for one minute, feel bad,” he said. The voice recognition technology Amazon developed for the Fire ultimately turned into Alexa.
The bottom line: Wall Street’s obsession with quarterly results can cause investors to use the wrong scorecard, and that’s another reason stock prices can move in the wrong direction.
The timeline to profits. Fadell noted that the first iPhone was unprofitable but that this wasn’t a concern. Because sales were increasing, Apple would be able to lower production costs. Together with technology advances, management knew that the product would eventually yield profit. “You make the product, you fix the product, then you fix the business,” Fadell explained.
Companies pursuing a new idea are often underestimated because they’re judged prematurely. Consider Amazon. It was unprofitable for almost 10 years after its founding. Why? During that decade, the company was growing quickly, but it reinvested as much as it could into warehouses. The result is that it can now deliver packages to many customers the same day. That may have been Jeff Bezos’s vision from early on, but outside observers couldn’t see the roadmap he had in his desk drawer, and for that reason, Amazon was regularly criticized for its lack of profits. The most notable misjudgment: In 1999, Barron’s magazine ran a cover story with the headline “Amazon.bomb.”
How did Barron’s editors get it wrong? They had no idea where the company was headed, and for competitive reasons, Bezos certainly wasn’t going to tip his hand. This pattern repeats frequently, and it’s a key reason why stock prices often end up out of line with a company’s true long-term value. “All overnight success takes about 10 years,” Bezos later commented.
Timeline to bankruptcy. Sometimes, Wall Street makes the opposite mistake, failing to see when a company is headed into decline. The most famous example in this category may be Kodak, which was the dominant maker of film for traditional cameras. Remarkably, it was a Kodak engineer who invented the first digital camera all the way back in the 1970s. But recognizing the threat it represented, the company shelved the project.
Over the course of the 1980s and 1990s, other companies introduced digital cameras, with the result that, between 1990 and 1997, Kodak’s revenue dropped almost 25%. And yet, throughout that period, its stock kept rising, hitting an all-time high in 1997. Investors just couldn’t appreciate the reality of what was happening. But then, just five years later, Kodak filed for bankruptcy.
In general, and on average, stock prices do reflect the value of public companies. But for all the reasons Fadell cites, that relationship is often imperfect. This is a fundamental reason why, in my view, investors are best served by choosing diversified index funds rather than trying to pick individual stocks.
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 X @AdamMGrossman and check out his earlier articles.
I agree with Fadell’s thesis but I see the topic a little differently. If an investor can recognize the true long-term positive or negative potential of a company’s actions vs. its current valuation they can achieve results better than index funds. To the examples of Kodak and Apple we can add Xerox, Sears, and a few other retailers wo missed the boat. I think good current examples of this future pricing uncertainty are Nvidia, TSM, and Space X. Nvidia’s challenge will be competition which will come from many directions due to their huge profit margins and relatively low barriers to entry, I am reluctant to buy it in spite of its popularity. I think TSM has unrecognized value because the real barriers to competing with it effectively from a volume and manufacturing cost perspective are very high, I worked in the chip industry for a long time and understand these barriers. SpaceX is a giant question mark in my book. Everyone loves Elon but Tesla’s valuation in terms of PE is in the stratosphere, the cybertruck has been a giant bomb. By contrast Starlink has been very successful. SpaceX has shown they can build rockets successfully but no responsible person would use a commercial airplane designed by their team based on their design methodology which is not focussed on avoiding system failures.
Bill
Hi Adam, thanks for another insightful article! I totally agree with you that “investors are best served by choosing diversified index funds rather than trying to pick individual stocks”. I spent most of my professional career with a Fortune 500 company. The company many years ago was even the most valuable company in the world. Now it is just a fractional of its former self. Today’s winners can easily be tomorrow’s losers. For us as average retail inventors, we should take the long view with most of our portofilo in index funds, then perhaps 5% or less as the “fun money” to pick or invest in whatever crazy things we want to. Thank you for your weekly lead articles to keep HD.com going strong.
I sold Kodak products for nearly 40 years. It was responsible for about 50% of my income. Kodak was a wonderful company and they did invent digital imaging. However, the digital information had lower resolution making it worthless without an inexpensive way of printing or displaying the image. The onset of more powerful PC’s in the 90’s made digital imaging far more practical. We used to sell Kodak products to one of our customers who created the prepress film work for the Saturday Evening Post. It required close to $400 in film and related materials to create the cover of the magazine. Today it would cost less than $10.
Kodak realized their mistake, but it was too late. They tried to catch up by making acquisitions, however, they threw good money after bad products. As a result, their new “digital” management wasted Kodak’s war chest of money. Like Kodak, our sales rapidly declined. So, we closed our business in 2012, liquidated our inventory, collected the receivables, paid all of our bills, fired all of our wonderful employees, and retired.
We enjoyed the ride up with Kodak and went down the drain with them.
Thanks Adam for another thought provoking article. We appreciate each and every one, and we continue to learn the human spirit of investing. Keep them coming and thanks.
Another good one by Adam. “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”– Benjamin Graham
I wonder what you think about SpaceX? Of course other than to say not to buy individual stocks….
Adam, thank you for another great argument of the value of index funds.