Why some good stocks are not good enough

August 29, 2019 11:35
Tech stocks thrive on their innovation ability and are less dependent on external macro factors. Photo: Reuters

Investors say they should avoid investing in the wrong stocks. But in my view, they should also avoid certain good stocks – if they are not good enough.

Billionaire investor Warren Buffett once said: “Let’s say that I offer to buy you the car of your dreams. It’s the only car you’ll get in your entire life. You’re probably going to read the owner’s manual four times before you drive it; you’re going to keep it in the garage, protect it at all times, change the oil twice as often as necessary.”

By the same logic, if we only have one chance to invest, we would be forced to pick only the best companies. There might be, say, 30 stocks with upside potential, but you should narrow it down to the best 10.

If you keep studying and comparing different companies, you will eventually learn how to choose.

Let’s compare mainland natural gas distributors and technology firms. The former performs quite well, but still not as attractive as the latter.

Indeed, natural gas distributors have posted good interim results, and a number of them have rallied 50 or even 100 percent over the last five years, but the high volatility of their earnings and stock prices often give the investor a headache.

Why is the business and the stock prices volatile? There are a couple of factors.

For starters, Chinese authorities have yet to liberalize the pricing of natural gas, which from time to time lead to profit swings.

In 2014, when oil prices slumped, natural gas distributors were forced to slash prices to prevent customers from switching to other energy options. But state-owned upstream gas suppliers decided not to cut prices, and so distributors suffered from plunging profit margins.

Sometimes, demand surges and supply lags behind, and that also squeezes the distributors’ profit.

In 2017, the Chinese government was heavily promoting the use of natural gas during winter. As a result, natural gas suppliers had to pay high prices to secure gas sources.

The installation fee is another uncertainty. The fee has been reduced to 1,000 yuan (US$139.55)  from around 2,000 yuan a decade ago. But rumors crop up from time to time that the authorities want to scrap the fee altogether. When this happens, natural gas stocks typically get hit.

Rural areas have become a new growth point for natural gas consumption while demand expansion in cities has begun to moderate in recent years, thanks to the massive subsidy.

But that raises the question of whether local governments would provide such subsidies continuously. What if they become financially strapped and can no longer afford the subsidy.

These policy risks embedded in the upstream gas price, installation fee, and subsidy for rural users explain most of the volatility in the sector.

The biggest positive factors for natural gas stocks are macro elements such as environmental protection needs and low penetration rate.

On the other hand, tech companies thrive on their innovation ability and are less dependent on external factors.

Considering all that, both types of stocks are good, but tech stocks are relatively more interesting.

This article appeared in the Hong Kong Economic Journal on Aug 28

Translation by Julie Zhu

[Chinese version 中文版]

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Columnist at the Hong Kong Economic Journal