Is my stock fab or fad?

How to NOT invest in a house of cards?

Artwork Credits: ‘Nice and Serious’ on Dribbble

When Issac Newton saw an apple falling from the tree, he wasn’t thinking about stocks. However, his good old theory of gravity is as applicable in stock investment as it is for understanding of the universe. What goes up, must come down. This is why buying whatever is going up may not be the best investment idea.

Rule No 23 of the 25 rules of investing as given by money market expert and “Mad Money” host Jim Cramer is: Beware of the Wall Street hype. Loosely translated, the rule simply states: don’t get carried away by everything that’s going up. Sometimes stock analysts and firms support a stock because of their own interests, that keeps propelling the stocks upwards well beyond reason.

Gartner Inc developed a theory called Gartner Hype Cycle, a pattern that most technology innovations follow. Take a look -

Source: Gartner Inc

Hype stocks work in the same way. Recall the dot-com booms of the late 1990s when the tech-heavy Nasdaq reached a record high of $5,048.62 on March 10, 2000. Or the renewable energy boom (2004–2010) that led to multiple IPOs in the energy sector.

In fact, a more pressing example comes from the 3D printing boom between 2010 and 2014 when Stratasys stock rose from $15 per share to over $135 per share. During this time, 3D Systems (NYSE: DDD) had a similar spike after moving from the Nasdaq to the NYSE in late 2011.

Remember that in both cases, stock plummeted again shortly after that, and investment in 3D printing returned to a more normal rate of interest following a cycle of inflated hype.

So instead of keeping up with the Kardashians, it is important to ask:

Is my stock fab or fad? And how do you do that?

Here are some principles:

# Understanding how a hype stock works

When a stock is in great demand from institutional investors, it becomes a hype stock. Typically long-term investors see value in such a stock and expect ROI to keep growing. A hype stock enjoys above-market P/E ratios.

Typically a hype stock goes through four phases:

Stealth phase — So-called early smart investors see value in a stock and start to buy discreetly.

Awareness phase — Now word gets out, media covers it, the investment story is out. Everyone is suddenly investing in this stock.

Mania phase — Looking at the rising stock price, the stock becomes the talk of the market. Most buyers are tempted to buy this stock.

Blow-off phase — The hype slowly fades away when intelligent investors choose to stay put while those chasing the gold rush are done buying.

Is buying a hype stock always a bad idea? No, it is not.

When it might make sense to buy a hype stock?

In one or both of the following cases-

  • You believe in a thesis and you are prepared for the long haul
  • You are a trader, not an investor

However, in the long-run, it is important to consider the reasons for its hype if you wish to continue making money in the stock market.

When you decide to go with the hype, here are some implicit assumptions that you are making:

  • If the stock is going up, there should be a solid reason. So it should keep growing at the same rate.
  • It has made money in the last few months, so I should be able to get ROI just as quickly now as well.
  • It’s a big stock, it certainly won’t crash so soon.

# Stop chasing the fast and the furious

An important principle to remember is: demand is never infinite. The longer a stock runs its unstoppable course, the more likely it is to crash, unless there are very valid reasons for it to keep growing. What we are saying is: do not buy a stock simply because it has been going up now or it has given you profits in the past.

Second important principle while dealing with the temptation of a hype stock is: time in the market beats timing in the market. A wiser approach to any stock investment is to remain invested for as long as possible. This means you get to capture every drop of profit and let compounding work in your favor.

Third, recall the Nasdaq bubble 2000 or the COVID crash. You need to beware of specially the single-name stocks that achieved massive market caps but don’t have the profits to show for it. Such stock prices are driven by speculation and will change course without warning.

What do these principles really mean? They signal a vital investment principle: if you don’t have a good reason to buy it, don’t buy it.

So now the question is: What is a good reason to buy a stock?

In other words:

What constitutes a good stock?

# Good stocks have strong financial statements

Go back to basics: stock investment means you buy equity (essentially loaning money) in an organization, in return for a share of the profits (or a promise of them). Few important measures, thus, of a good stock include a balance sheet, income statement and cash flow, proving that the business is generating real money by selling real products or services. You do not want to own shares in a house of cards that tumbles at the first significant macroeconomic stress. A good stock is that of a company with strong financial statements, with real business of products or services and a history of braving financial storms.

# Good stocks have valuation and stability

Take for instance Walmart (WMT). It’s a company that sells products that people always need. As a result, it has a history of making profits regardless of a pandemic situation or a market crash. This stock always enjoys good valuation.

# Good stocks are from sustainable companies

In order for your stock to remain good, the company should be in a business whose products or services do not change often. Any significant or frequent change in core products or services directly affects the stock prices or valuation of that company. This is a company that has direct competitive advantage in the form of copyright licenses or trademarks. Dr. Jeremy Siegel (from Wharton Business School), who did one of the longest-term academic studies of equity market results, said:

boring is almost always more profitable.

What’s the bottomline then?

Investments that everyone’s chasing look tempting but often the boring ones yield profits consistently.

Stockal is a Global Investment Platform that helps retail investors in India & UAE “globalize” their wealth by investing money in mature global markets.