Investing involves risk, and while it is essential to recognize that every investment comes with its own set of risks, there are certain types of stocks that Peter Lynch recommends that investors should avoid due to their characteristics or the challenges associated with investing in them. Here are some types of stocks that investors may consider avoiding:
Hottest stock in the hottest industry
Investing in hot stocks in a hot industry can be tempting, but it’s essential to exercise caution and avoid blindly chasing trends without conducting thorough research and analysis. While there’s potential for significant returns, there are also risks associated with investing in overheated sectors or companies.
Hot stocks can go up fast, usually out of sight of any of the known landmarks of value, but since there is nothing but hope and thin air to support them, they fall just as quickly. If the investor is not clever at selling hot stocks, the profits quickly turn into losses, because when the price falls, it is not going to fall slowly, nor is it likely to stop at the level where the investor jumped on.
There are various hot industries where sizzle led to fizzle. Mobile homes, digital watches, and health maintenance organizations were all hot industries where fervent expectations put a fog on the arithmetic. Just when the analysts predict double-digit growth rates forever, the industry goes into a decline.
High growth and hot industries attract a very smart crowd that wants to get into the business. Entrepreneurs and venture capitalists stay awake nights trying to figure out how to get into the act as quickly as possible. If you have a can’t-fail idea but no way of protecting it with a patent or a niche, as soon as you succeed, you’ll be warding off the imitators. In business, imitation is the sincerest form of battery. This happened to disk drives. The experts said that this exciting industry would grow at 52 percent a year—and they were right, it did. But with thirty or thirty-five rival companies scrambling on the action, there were no profits.
Example – Xerox
There’s never been a hotter stock than Xerox in the 1960s. Copying was a fabulous industry, and Xerox had control of the entire process. “To xerox” became a verb, which should have been a positive development. Many analysts thought so. They assumed that Xerox would keep growing to infinity when the stock was selling for $170 a share in 1972. But then the Japanese got into it, IBM got into it, and Eastman Kodak got into it. Soon there were twenty firms that made nice dry copies, as opposed to the original wet ones. Xerox got frightened and bought some unrelated businesses it didn’t know how to run, and the stock lost 84 percent of its value. Several competitors didn’t fare much better. Copying has been a respectable industry for two decades and there’s never been a slowdown in demand, yet the copy machine companies can’t make a decent living.
The Next Something
Identifying “the next something” stocks can be a speculative exercise, and while some investors may seek to capitalize on emerging trends or potential market disruptors, there are risks associated with investing in stocks based solely on speculative hype or predictions. In fact, when people tout a stock as the next of something, it often marks the end of prosperity not only for the imitator but also for the original to which it is being compared. When other computer companies were called the “next IBM,” you could have guessed that IBM would go through some terrible times, and it has. Today most computer companies are trying not to become the next IBM, which may mean better times ahead for that beleaguered firm.
Examples:
Nikola Corporation, a manufacturer of electric and hydrogen-powered vehicles, gained attention as a potential competitor to Tesla in the electric vehicle market. However, the company faced allegations of fraud and misleading investors about its technology and product capabilities. Nikola’s stock price plunged, and its founder resigned amid the controversy.
However, Nikola’s trajectory has been quite different from Tesla’s, and it has faced numerous setbacks and controversies that have raised doubts about its future prospects. Here are some key points to consider:
Technology and Product Development: Unlike Tesla, which has successfully brought several electric vehicle models to market, Nikola has faced criticism and skepticism regarding its technology and product capabilities. The company has yet to deliver any commercial vehicles, and questions have been raised about the viability of its hydrogen fuel cell technology.
Leadership and Governance: Nikola has experienced turmoil in its leadership ranks, including the resignation of its founder and executive chairman, Trevor Milton, amid allegations of fraud and misleading investors. The company’s corporate governance practices and transparency have also been called into question.
Partnerships and Strategic Alliances: While Tesla has established partnerships and collaborations with established automakers and technology companies, Nikola’s partnerships have faced scrutiny and skepticism. The company’s deal with General Motors fell through, and it has struggled to secure the necessary resources and expertise to bring its vehicles to market.
Financial Performance and Market Sentiment: Nikola’s stock price has been highly volatile, reflecting investor uncertainty and skepticism about the company’s prospects. The stock experienced a significant decline following allegations of fraud and misleading statements by its founder, and it has yet to fully recover.
Regulatory and Legal Challenges: Nikola has faced regulatory and legal challenges, including investigations by the Securities and Exchange Commission (SEC) and Department of Justice (DOJ) into allegations of fraud and misleading statements. These investigations could further impact the company’s reputation and financial performance.
While some investors may have initially viewed Nikola as a potential competitor to Tesla, the company’s challenges and controversies have cast doubt on its ability to deliver on its ambitious plans. While it’s essential to remain cautious and conduct thorough due diligence when evaluating investment opportunities, it’s also important to recognize that each company has its own unique circumstances and challenges. Comparing Nikola to Tesla as a “next Tesla” failure overlooks the complexities and nuances of each company’s situation.
DiWorseification
Instead of buying back shares or raising dividends, profitable companies often prefer to blow the money on foolish acquisitions. The dedicated diworseifier seeks out merchandise that is (1) overpriced, and (2) completely beyond his or her realm of understanding. This ensures that losses will be maximized.
Every second decade the corporations seem to alternate between rampant diworseification (when billions are spent on exciting acquisitions) and rampant restructuring (when those no-longer-exciting acquisitions are sold off for less than the original purchase price).
These frequent episodes of acquiring and then regretting, only to divest and acquire and regret once again, could be applauded as a form of transfer payment from the shareholders of the large and cash-rich corporation to the shareholders of the smaller entity being taken over, since the large corporations so often overpay.
From an investor’s point of view, the only two good things about diworseification are owning shares in the company that’s being acquired, or in finding turnaround opportunities among the victims of diworseification that have decided to restructure.
Example – Gilette
The follies of Gillette are many. That company not only bought the medicine chest, but it also diworseified into digital watches and then announced a write-off of the whole fiasco. Gillette has made major reforms and later mended its ways.
In practice, sometimes acquisitions produce synergy, and sometimes they don’t. Gillette, the leading manufacturer of razor blades, got some synergy when it acquired the Foamy shaving cream line. However, that didn’t extend to shampoo, lotion, and all the other toiletry items that Gillette brought under its control.
Buffett’s Berkshire Hathaway has bought everything from candy stores to furniture stores to newspapers, with spectacular results. Then again, Buffett’s company is devoted to acquisitions. If a company must acquire something, preferably it should be a related business. There’s a strong tendency for companies that are flush with cash and feeling powerful to overpay for acquisitions, expect too much from them, and then mismanage them. A much better option would be a vigorous buyback of shares, which is the purest synergy of all.
Whisper Stock
“Whisper stocks” is a term used to describe stocks that are being recommended or discussed in a secretive or confidential manner among a select group of investors or within certain circles. These stocks are often touted as having significant growth potential or being undervalued, and the information about them is typically shared through informal channels such as word-of-mouth, online forums, or private newsletters.
These are the longshots: the company that sells papaya juice derivative as a cure for slipped-disc pain (Smith Labs); jungle remedies in general; high-tech stuff; monoclonal antibodies extracted from cows (Bioresponse); various miracle additives; and energy breakthroughs that violate the laws of physics. Often the whisper companies are on the brink of solving the latest national problem: the oil shortage, drug addiction, AIDS. The solution is either (a) very imaginative, or (b) impressively complicated.
Middlemen Stocks
The company that sells 25 to 50 percent of its wares to a single customer is in a precarious situation. If the loss of one customer would be catastrophic to a supplier, the investor should be wary of investing in the supplier. Disk-drive companies such as Tandon were always on the brink of disaster because they were too dependent on a few clients. Short of cancellation, the big customer has incredible leverage in extracting price cuts and other concessions that will reduce the supplier’s profits. It’s rare that a great investment could result from such an arrangement.
AltaVista was one of the earliest and most popular Internet search engines during the early days of the World Wide Web. While not a traditional middleman stock in the same sense as e-commerce retailers, AltaVista operated as an intermediary between internet users and online content by providing search engine services. Despite its initial success, AltaVista struggled to compete with emerging search engine competitors such as Google and Yahoo. The company’s stock price declined, and it was eventually acquired by Yahoo in 2003.
PVR Limited – Movie exhibition companies, also known as cinema chains or theater operators, can be considered middlemen in the entertainment industry, as they serve as intermediaries between film studios and moviegoers. PVR’s stock price experienced a significant decline during the lockdown period, reflecting investor concerns about the company’s financial performance and the impact of the pandemic on the cinema exhibition industry. The stock price plummeted as cinemas remained closed and there was uncertainty about when they would be able to reopen.