Many active investors buy stocks on the hope of scoring outsize returns by purchasing the next Apple or Tesla. They also might remember eras such as the dot-com bubble or the housing boom and assume that investing is a path to easy money.
However, in truth, even most money managers underperform the S&P 500 index. One reason Warren Buffett has become so respected is his track record of beating the index year after year.
Yes, Buffett knows how to read balance sheets and cash flow statements. He can also determine a bargain when he sees it. Nonetheless, he has shown the patience to buy when stocks fall to their lows and the discipline to hold companies he supports, even if the market does not believe in those companies for a time. For all the focus on undiscovered bargains or earnings beats, the most crucial factor in successful asset allocation may actually be emotional discipline.
Image source: Getty Images.
The patience to wait
Emotion often plays a huge role in buying decisions. When investors see a stock rapidly moving higher, they might feel an impulse to buy. The opposite problem may appear when a good stock seems to do nothing but fall in value. As stocks fell in late February and early March, many did not want to buy, because falling prices bred fears that the value of stocks would continue to plunge.
However, the decline made stocks such as Square (SQ +0.07%)a relative bargain. Square traded close to $100 per share in 2018, and today it sells for roughly $78 per share and has a P/E ratio above 118 times. Investors continue to buy. Still, its recent history shows the possible returns that prospective buyers can earn by waiting.
In the depths of coronavirus-inspired selling, Square stock fell as low as $32.33 per share. This took the P/E ratio to just below 50. Earnings growth is expected to reach 33.06% per year over the next five years, meaning a price-to-earnings-to-growth (PEG) ratio of approximately 1.5 times. Recent history has shown Square stock tends to move higher after reaching that PEG ratio. So bulls who had enough patience to wait for the PEG ratio to reach this level earned higher returns.
The future of Square's industry is also an important factor. Given the extensive ecosystem that this payments company has built, one could compare it to Amazon, arguing that this is the Amazon of financial services. Like Amazon, it has developed an extensive ecosystem, a feature that has helped companies like Amazon and Apple stand above the competition. However, despite this promise, investors have to remember that the higher the price, the more potential a stock has to turn negative.
The courage to hold
Understanding an industry's direction has also helped with Teladoc Health (TDOC +2.58%). After learning about telehealth, one could reasonably predict that more medical appointments would take place online versus in person, with or without a pandemic. After researching this industry, most would probably conclude that Teladoc is the leading telehealth company. Moreover, Teladoc received an unexpected boost when the COVID-19 pandemic caused both patients and investors to flock to the company.
Nonetheless, holding on to Teladoc stock has become a difficult feat over the years. Teladoc launched its IPO on July 1, 2015, and the stock closed at $28.50 per share on its first trading day. However, nine months later, Teladoc stock fell to a low of $9.08 per share. This means that investors who bought on the first day and held for more than nine months saw more than two-thirds of their initial investment wiped out. Holding Teladoc after such a loss was tough even for those who believed in the future of telehealth.
Other difficulties could persuade emotional investors to sell. Analysts do not forecast a profit for Teladoc until at least 2022. Also, despite the surge in business that came from coronavirus, the company managed to miss estimates in the last quarter.
Moreover, the company does not possess the strongest competitive moat. All a competitor needs is licensed practitioners and call center infrastructure. This is a plausible reason to sell should the stock begin to trend downward.
Yet despite these factors, Teladoc could still become the Apple of telehealth. Why? Because analysts predict a 15.1% compound annual growth rate (CAGR) for the industry.
As you can see, investors face numerous decisions that can set off emotions. To remain optimistic about Teladoc, investors will have to fight severe doubts, both about the stock price and about the company's competitive position.
Leave emotion at the door
Both Square and Teladoc will likely become more prominent stocks in the future. Nonetheless, investors have no reason to make the emotional decision that they must own either name. Yes, these stocks have become popular, but that does not mean everyone has bought these stocks. Warren Buffett's Berkshire Hathaway does not own a stake in either company, and it will probably prosper even if it never does.
If Square or Teladoc becomes relatively cheap, investors can consider them. However, they should treat the financials and the future of a business as the buy criteria. And even if those stocks never meet the appropriate benchmarks, plenty of other companies probably will.
In the end, successful portfolios will be built on reasonably priced companies with solid fundamentals, not those bought on a emotional whim.
