How We Evaluate the Risk and Reward of a Stock

No one has yet found the perfect formula for picking stocks.  It is more of an art than a science, as numerous changing variables affect a stock’s price.  Some are easy to spot and analyze, but many are unforeseen.  Understanding the fundamentals of a company is one aspect of the process, followed by making a judgment about how much of the company’s strengths and weaknesses are priced into the stock’s current share price.

MasterCard is widely held in our portfolios and was first purchased 10 years ago.  What attracted us to MasterCard was its steady and rapid earnings growth, and the perceived sustainability of that growth.  MasterCard (along with Visa and American Express) has strong networks around the world to process credit card transactions for electronic forms of payment.  The trend of using less cash to pay for our transactions has been a strong tailwind for these companies.  The last ten years have been great, but what will happen in the next ten?

There are concerns that new competitors such as PayPal, Block, and cryptocurrencies, like Bitcoin, will reduce growth at MasterCard.  As far as the price of MasterCard stock, it is selling at 35 times forward earnings estimates, which is a healthy premium to the overall stock market.  We think it deserves that premium as its network is quite defensible, but we will keep watching what develops.

Sometimes stocks just reach price levels that are hard to sustain.  Microsoft is a great example when it went became the belle of the ball, selling at 74 times earnings in 1999, at the top of the tech bubble.  Afterward, it declined by more than 50% and then went sideways for 13 years. Today, it is back in favor, after years of strong growth in the Office365 suite product and other services, and is now selling at a justifiable 33 times earnings. 

When we see big swings in the overall market, such as the selloff at the emergence of Covid, it helps us keep our focus by asking where these stocks would be priced three years from now, if things return to normal.  In summary, fundamentals matter, and the price you pay matters,--but no decision process is foolproof.  We will continue to combine knowledge with experience and logic to avoid extreme risks and put the odds in your favor for future gains.