Never Buy A Stock People Expect to Do Well

Benjamin Stein and Zachary Sternberg were two college students with an interesting background. They founded a hedge fund in college called Spruce House Investment Management. It managed billions of dollars for prestigious clients, including Massachusetts Institute of Technology.

As people who spent all their time “devouring Warren Buffett’s annual letters,” they wanted to become the next Warren Buffett.

In their first few years, they were very successful. They generated 18% returns after fees, compared to about 8% for the S&P 500. Their success was so unprecedented that they were even asked to contribute to an updated version of Security Analysis, a book written by Warren Buffett’s mentor Benjamin Graham.

But in 2019, they shifted their portfolio into several growth stocks, including Carvana and Wayfair, each of which they owned millions of shares in.

Initially, the stocks did very well. Carvana went from $80 in 2019 to as high as $360 by 2022.

Wayfair went from $150 in 2019 to $340 in 2022. “By mid-2021, [their portfolio] was compounding at 20% per year now, nearly twice as fast as the S&P 500,” according to the Wall Street Journal. As Benjamin and Zachary wrote: “In very short order we have been able to put Spruce House in the flow

of some of the highest quality venture and growth equity opportunities.”

But then things changed.

Wall Street had ridiculously high growth expectations for each of these stocks. They believed Carvana would consistently hit triple-digit growth rates, and Wayfair would hit 40-50% growth

every year.

It’s almost impossible for any company to live up to such high expectations.

Guess what happened?

One day, both of those companies failed to meet those high expectations. When that happened, both stocks crashed. Carvana and Wayfair fell 98% and 90%, respectively.

Those stocks—and other growth stocks as well—fell so much that Benjamin and Zackary lost two-thirds of their clients’ money by the end of the year, resulting in their fund being ranked as

among the “Ten Worst Performing Hedge Funds,” according to Value Walk.

Benjamin and Zackary’s story illustrates a valuable lesson: never buy stocks that everybody expects to do well.

In the workplace, employees under-promise and overdeliver.

Why?

If an employee sets expectations unrealistically high, it becomes hard to surpass expectations (and hence make the boss happy).

The same concept applies to stocks. The higher the expectations rise, the bigger the fall becomes when a company fails to meet them.

If Wall Street has high expectations for a stock, it’s almost impossible for management to please investors. In other words, if a stock has high expectations, it’s hard for the company to overdeliver. The result is that the stock almost always underperforms.

During the dotcom bubble, Wall Street developed ridiculously high expectations. “This tech company will become the next IBM,” they said. “This other tech company will hit a billion-

dollar valuation,” they said. But the companies were never able to live up to those unrealistic expectations. And as soon as Wall Street realized that they sold off those stocks, and they came

crashing down.

While we don’t see dotcom bubbles every single day, we do see the same thing happen on a smaller scale all the time.

In 2020, Wall Street developed high expectations about Nikola’s future. One investor predicted that it would become one of the leaders in the entire electric vehicle space. Another investor predicted that it posed a major threat to Tesla’s market share. In short, everyone expected it to perform extraordinarily well. However, the company never lived up to those expectations. The stock crashed from $1977 to less than $5 per share, making it one of the worst performing stocks in recent years.

The biggest warning sign that a stock has high expectations is if it appears like a “hot stock.” Oftentimes, people will email me, “do you think [insert stock name] is a good company to invest in?” Almost always, the company they are inquiring about is always a stock that’s hot in the moment. Some recent ones included: Beyond Meat, Nikola, and Nvidia.

Be careful of hot stocks.

It’s counterintuitive advice. Everyone loves to invest in companies that they expect to perform well. But the truth is that the stock that everyone expects to perform the best has the highest chances of missing expectations (and hence underperforming).

What you want to do instead is buy stocks that nobody wants…