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The household name trap

Newer investors are a feature of the post-Covid investing landscape. Whether they are sports bettors who found their favourite games shut down, or Reddit traders with time and money on their hands, this influx of new traders and investors has altered the market landscape. While the principles of successful investing remain the same, the changed market conditions bring different opportunities and risks.

An example is the highly volatile moves in the share price of the previously obscure GameStop. This smaller video game retailer was a favourite of short sellers, convinced the bricks and mortar nature of its business would succumb to digital disruption. A growing number of Reddit traders, in a forum known as WallStreetBets, began following, and then buying, GameStop. As more and more Redditors caught on, the share price took off, in some cases delivering huge profits. The “short squeeze” illustrated the changes these retail investors brought to the market.

Another market impact is the premium paid for household names. Legendary investor Benjamin Graham, and his follower Warren Buffet, are often reported to buy only businesses they know and understand. Many retail investors believe they are following this maxim when they buy into stocks like Facebook, Apple, Amazon, Alphabet and Netflix. Woolworths is a good Australian example. Unfortunately, the support for these household names maybe a misunderstanding of the words of the Sage of Omaha.

It’s true that Mr Buffet’s Berkshire Hathaway fund has done very well from buying into household names like Coca Cola, and is an enthusiastic consumer of its product – at least in public. However, the fund also holds obscure companies that many investors have never come across. With hundreds of billions of dollars under management, it must. The investment approach is about examining a company closely to understand its business model and its prospects, not buying into companies that produce products an investor uses.

This household name effect is why one of the most common questions in international investment webinars asks “is it too late to buy US tech stocks?” The right answer to that question relies on individual circumstances, as well as the market outlook. However, on a risk to reward basis, the answer may be “yes”.

The challenge is not just the spectacular share price rises and the eye-watering valuations. The very popularity of these technology companies may sow the seeds of their eventual underperformance.

In trading terms, many of these well-known names now represent a crowded trade. When a crowd gets behind a stock or sector, it is initially good news, especially as more investors join the crowd. The problem comes when a number of investors believe it is time to sell all at once. There are plenty of possible triggers for a sell off, including a poor report from the company, a downgrade from a prominent analyst or increase in interest rates.

Chart: Is Amazon’s (candles) outperformance of the Nasdaq (green line) coming to an end?

Whatever the spur, when the selling starts it can accelerate very quickly. Falls in the share price become a signal in themselves. Things can get very ugly if everyone heads for the exits at the same time. This is why investors could choose to comb their portfolios for household names. It’s possible these stocks will continue to rise, but investors must assure themselves that staying in these stocks is worth the risk of a stampede trampling their portfolio returns.

Investors more confident of further gains to come could consider rotating into other, less well-known stocks in the same sector. The CMC Markets Pro platform allows investors to view international stocks by sector. Pulling up the sector in which an investor holds household names and examining the research around less well-known names with more attractive valuations, may allow them to stick with a sector they like while also lowering risk.

Investors comparing stocks in the technology sector may prefer to compare ratios such as Price to Sales or Price to Cash Flow. Many of these businesses are re-investing profits, meaning the more traditional Price to Earnings ratio is a less useful comparison tool.

The sun is shining on US stocks, particularly the technology sector. However, the rain will come again. Investors may do well to remember that umbrellas are always cheaper when the sun is still shining.