How do you pick your stocks? Do you follow a certain adviser? Use a dartboard? Ask your dog or cat? There are many methods. There’s one standard piece of advice that may work against you, though, and that is to stock in the companies whose products you buy and use all of the time.
In theory this is great advice, because if you like something it must be doing well. Many people invest on this basis. When all else is equal, a stock’s price is simply supply and demand. That’s the problem. If many people are choosing stocks based on what they like, the price will go up. You will be paying more for the security of recognizing the company of which you own a piece.
For example, what if you want buy stock in Hershey’s. Everyone loves Hershey’s chocolate, and they will probably be in business at the end of the century. When you buy it the stock price is $60 (made up numbers). Between capital gains and dividends, the company gives you $5 a year per share. The return you are getting is $5/60, or 8.3%.
Hershey’s is a blue-chip stock. Supposedly it is not in any danger because the product the company sells or service it provides is in so much demand that nothing could ever make the company go out of business. Other blue-chip stocks of the past include Enron and General Motors, both of which went bankrupt. Even companies like Disney have fallen on hard times through bad management. These stocks are not as safe as they seem.
In comparison, suppose you do some digging and find the Easter Egg Dye Company (made up company) that makes the dye that everyone in California has used to dye their Easter Eggs for the last 20 years. Yes, they’re a local phenomenon, but it’s a big local market. Plus their product isn’t expensive, so it isn’t as exposed to economic downturns as bigger-ticket items.
You find out that they’re traded on NASDAQ, and that they generally return about $5 a year. However, no one knows about them, so their stock price is $45. That’s a return of 11% for a stock that is not exposed to worldwide fluctuations in the cocoa market. It’s definitely the better buy.
This would be a small-cap stock, and there are some very solid companies among them. You can get mutual funds of them, and they are an excellent hedge against the more conservative and low-paying standard portfolios. But digging around also reveals some good deals as well.
Look for companies that specialize in fewer products. One mouthwash on the shelves boasts that it never sells under a generic label (many do) and yet it retains its spot among the best. That’s a solid choice. At my last check Buffalo Color Corporation, of which people in Buffalo have rarely heard, makes about 50% o of the world’s supply of indigo, which is made to color blue jeans. Those aren’t going anywhere. Also keep your ear to the ground about even more local companies, like Eat-and-Park in Pittsburgh, to see if some owners want to sell stock in a private placement, meaning off of the markets. These can be excellent investments indeed.
It can be difficult to say when small capital stocks are at the same risk level as a blue-chip. Always check the financial statements. But in truth, if you want a guaranteed rate of return, you should be investing in treasury bonds. You are taking a risk with any stock. You deserve to get the best return possible.