Don't count on the blue chips

The February 12th issue of Time features a story called "China Braces for a Bubble." The piece points to numerous signs of an unsustainable speculative bull market including novice investors with no experience in the market borrowing money to invest in stock, astronomically high price/earnings multiples, and price discrepancies (shares trading at widely different prices on different exchanges.

But Lan Xue, head of China Research for Citigroup Inc. (NYSE:C), tells us not to worry: "Judging from history, the stock market doesn't bust when the buying is concentrated on blue-chip names. It's when the buying goes into the second line, third line, fourth line [companies] --the speedy names -- this is what would get me more worried."

Oh really. Investors who lost money buying the Nifty 50 during the 1960's and 70's would be surprised to learn that blue-chip stocks can become grossly overvalued as well. Andrew Tobias, author of The Only Investment Guide You'll Ever Need, summed up the Nifty 50 bubble well on his website. Nor should investors content themselves with the belief that the rapid growth that is probable in China will lead these stocks to be strong performers. I would argue that the most important lesson for every investor to learn is this: a good business does not a good stock make. Valuation matters. From Tobias's site:

Well, Avon was close to 140 in mid-1973 and under 20 by the Fall of 1974 (and what a Fall it was)... Disney dropped from 210 at the end of 1972 to 31 less than two years later...The fall wasn't fast in the sense of its taking just a week or two...But these companies were basically doing fine...just their stock price multiples that were deflating. Where once they had been selling at 60 times earnings, the world changed and now they were selling at 15 or 20 times.