Popular stocks aren't always great investments

Morningstar’s data journalist Sachin Nagarajan shares 3 important lessons to keep in mind.
By Morningstar |  05-11-20 | 
 

A popular investing trend has been buying stocks that have benefited from the work-from-home and shelter-in-place trends during the pandemic. Facebook, Apple, Amazon, Netflix and Alphabet (the parent company of Google), or the FAANG stocks, have seen a lot of attention. Other technology stocks, like cybersecurity, have also seen their stock prices rise.

The table below lists the technology stocks that are in the Morningstar US Large Cap Index, which holds the largest 191 U.S. stocks weighted by market capitalization. You'll recognize many, as they also dominate the news.

NOV 5 - A

Before purchasing a stock, look at its economic moat, or sustained competitive advantage. A company without a moat can be a good business, but it has less protection against competition. And even a company with a moat may not be a good investment if its stock is trading at a price higher than what it's worth, or its fair value.

Only three of the tech stocks in the Morningstar index – Cisco, Intel, Uber Technologies - are trading below their fair value, all the FAANG names are missing. Though FAANG stocks are strong businesses, their current prices are generally at or above fair value estimates. Recently market volatility has made Google and Microsoft more attractive than normal.

The valuations of technology stocks illustrate the risk of following investing trends. It's harder to buy stocks that are going to go up if you aren't buying stocks that are undervalued in the first place.

Some investors may think technology's outperformance over the past decade will continue for the foreseeable future. Brian Colello, Morningstar's director of the technology sector, says current prices are too high, and a pullback would be welcome. Tech may continue soaring for a while, but we expect it to fall back eventually.

3 important lessons

  • Investing in stocks successfully means buying low and selling high, so valuation is essential to stock selection.
  • Asking why certain stocks are in the news and whether they are good investments are two very different questions.
  • Purchasing a stock enables you to become a part-owner of the business. This means you should answer two questions: 1) Is it a good business? and 2) What is it worth?
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