Just because you use it, doesn't mean you should own it
Quick Disclaimer: I am only using Snapchat (NYSE: SNAP) in this post to illustrate a point and drive home an important investing lesson. This post is in no way, shape, or form a recommendation to buy or sell any of the stocks mentioned herein. I don't currently own nor do I plan to initiate positions (long or short) in any of the securities discussed within the next 72 hours.
I've been sitting on this post for a couple months now, and today is as good a day as any to publish it. When Snapchat announced it was going public earlier this year, a handful of friends said they were excited to buy stock in its IPO, exclaiming that they wanted to “get their hands on the next Facebook”. For a few, this would be their first foray into the stock market, and all they could see were dollar signs.
In the spirit of friendship and diligent investing, I played devil’s advocate as best I could. I asked what made them think SNAP was a good investment, what their price target was, and suggested they should probably do some more digging before committing a lot of money to the stock.
But for the most part, I kept my mouth shut. I'm not (currently) in the business of making positive or negative stock recommendations, and I honestly haven't analyzed SNAP’s prospects. Plus, sometimes the best lessons are learned the hard way.
Fast-forward to last night and this morning, those same friends were panic-texting me after Snap reported its first quarterly earnings as a public company. They wanted to know what was going on, why the stock had dropped so much, and if they should do anything about it. Again, I'm not in the business of making stock recommendations (yet, anyway), so my response was essentially the following.
There’s no pretty filter for ugly earnings
Numbers don't lie, and Snap’s earnings numbers, from revenue to new users, came in lower than expected. These lackluster results sent the stock tumbling as much as 25% in after-hours trading yesterday, and created a 20%+ sell-off in the stock during today’s regular trading hours. At around $18.00, the stock is down 25% from its $24.00 opening price on March 2nd, and is just above its IPO price of $17.00.
The millennials who decided to dip their toes into the proverbial stock market waters for the first time are now finding out that the water can be a bit colder than they had anticipated. Some have seen their account balances drop hundreds, even thousands of dollars depending on how many shares they bought to begin with and what price they paid, and most are wondering what to do now.
They bought what they know and use religiously. Where did they go wrong?
THE PROBLEM WITH THE “BUY WHAT YOU KNOW” MANTRA
It's not the holy grail of investing some make it out to be
A lot of money coaches, investing course creators, etc. hawk the “buy what you know” mantra as the holy grail of investing. They tell you to go around your house looking for products you use daily that are created by publicly-traded companies, or check your phone or computer for services and apps that you use on the reg, suggesting those are great investment opportunities.
This isn't terrible advice in theory; building wealth involves being both a consumer AND an owner. Owning stock in companies you're familiar with is a way to combine the two. Warren Buffett, for example, has made a significant amount of money by investing in companies like Coca-Cola whose products he consumes and understands well.
However, I, like Warren Buffett, know that there’s a lot more to picking winners than just being a customer of a stock that you own. That’s why, from a fundamental investing perspective, the basic logic behind this mantra is flawed.
It comes down to the fundamentals
Some of my most successful investments have been in companies I had never even heard of before. I won't get into how you find such stocks in this post (long story short, it involves screening for certain qualities), but it’s true.
How can that be, you ask? Because at the end of the day, making money in a stock is about the company’s fundamentals.
“Fundamentals” refer to things like revenue, customer growth, cash flow, cost control, and strong management, things that create additional shareholder value. That’s what makes stock prices go up and down in the long run. Whether some product is the hottest thing since sliced bread, or a certain stock is the most exciting IPO of the year really has no bearing, fundamentally, on the stock’s future success.
Here’s why: If a company can't figure out how to turn a new fad into higher sales and/or greater profits, the benefits of that new trend won’t flow down to you as a shareholder. And if there isn’t additional value flowing to shareholders, other investors won’t be incentivized to buy the stock, which means the stock price won’t go up. Therefore, investing in a company that can’t translate “cool” into “cash” probably won’t make you money in the long haul.
(If you want to learn more about stock prices, click here for my Why Stocks Go Up & Down video and explainer post.)
How Does This Apply to Snapchat?
As illustrated in their earnings report yesterday, SNAP’s fundamentals, particularly revenue, profit, and user growth, aren't as strong as everyone expected them to be. Since analysts had initially based their price targets on higher fundamentals, they now have to ratchet down their forecasts to reflect slower growth. Delayed profitability and slower value creation translates into lower stock prices.
That's what caused the selloff today - investors were worried they wouldn't make a large enough return owning the stock at that price anymore, so they sold it.
To give you some perspective, the types of “money-making” stocks I typically invest in are characterized by solid fundamentals, such as:
- Strong revenue growth
- Steady or increasing profit margins
- Proven track record
- Experienced management at the helm
- Low competition
Right now, SNAP (along with a lot of other new-age tech companies) lacks those qualities. The company is run by young, inexperienced management. It has no track record to speak of, faces serious competition from Facebook and Instagram, and offers a different setup and user experience when it comes to advertising, its primary source of revenue.
Now, that’s not to say that the company and stock won’t be successful. Many investors expect SNAP will work through its growing pains like Facebook did and make them a ton of money. There is execution risk, however. Investors need to be aware of it and understand how it may cause volatility in their accounts in the near-term.
The Investing Lesson to Be Learned
Long-story short, today’s tumble illustrates that there's a lot more to picking winning stocks than just “investing in what you know”. Loving a product doesn't necessarily mean you should own it. Simply having great tech and a hot young CEO who’s engaged to a supermodel isn't the recipe for stock success. Good fundamentals are.
The investing lesson that millennials can learn from Snapchat is to not be blinded by pretty filters and sparkly overlays, but rather aim to understand what's behind the mask.
A product or service that you and all your friends use won't necessarily translate into a good stock. So instead of viewing the “buy what you know" mantra as solely “invest in companies you're familiar with”, rather I encourage you to think of it like this:
Invest in companies you know inside and out.
This alternative interpretation implies that you should base your investment decision on more than just your opinion of a company’s product. You should do research, understand the company’s financials, growth drivers, risks, and strengths and weakness. You should decide on price targets and a holding strategy, then commit to it BEFORE buying a share.
What to do if you own SNAP?
Again, I can't tell you that. I haven't analyzed the company’s fundamentals because tech isn't a sector I typically “play” in. I will say that the current fundamentals don’t look promising, but that could change. This quarter’s earnings could very well be a blip on the radar, after which the stock could soar to higher prices like Facebook did. On the other hand, this could be the beginning of worse times to come.
I don't know, nor do I have a strong opinion one way or the other. I’m simply leveraging this recent event to teach an important investing lesson.
Only time will tell whether the company can overcome these growing pains. In the meantime, it's YOUR job as the steward of YOUR money to do some research and make educated decisions about any investments you enter into.