Lots of stocks have been getting killed in the last several weeks and the declines don’t seem really like they’re set to abate headed into a week where news is again at a premium (sure, earnings, but it’s just a few names, and they’re mostly decidedly not in this category of the momentum names that fueled the rally in 2013). So the likes of Facebook, Tesla Motors, Netflix, Alexion Pharmaceuticals, and a bunch of others have seen their fortunes turn in the market. But at this time we thought it would be a good way to get into this topic again by trying to lay out just what the hell a momentum stock is in the first place, because they exhibit a number of characteristics beyond just “a stock that’s going up very high.” So here goes:
Growing Industries: Internet retail, internet security, solar, cloud computing, companies that use the cloud for providing services (think Salesforce.com), biotechnology, and anything else where the prospects for growth are big and related to a growing sector of the economy. Utilities don’t really qualify here, naturally. The reasons are two-fold: for one, in order to jump onto a rising growth story, you’d want to be in a place where the expected future returns outpace the returns you’re getting now, something you won’t get from the telephone company, someone who sells toothpaste, or the guys hooking up the electricity.
Revenue, Revenue, Revenue: Credit Suisse’s quantitative research models shows that the big winners in 2013 were those whose price when compared to enterprise value showed most of the value in the stock wrapped up in their future growth prospects. Lots of these types are showing a big boom in the money they’re bringing in every year, even if that’s not translating yet into earnings – Tesla, for instance, saw its revenue rise by about 75 percent in 2011, which then doubled in 2012, and increased nearly four-fold in 2013. That’s growth, and that’s what feeds the expectations for more growth. The exception here is probably biotechnology, where much of the prospects are given over to expectations for a drug approval – though it’s notable that Alexion, for example, has posted revenue growth of 37 percent or better for five years running.
Rising Stock Price: This is sort of a no-brainer, but it’s a little more nuanced than just “OMFG LOOK AT THAT.” (Ok, maybe not much, but let’s unpack it anyway.) There’s a lot of talk about stocks that steadily rise and then go through a period of what people blandly call “consolidation,” but in a sense that kind of thing is important – it means that investors are seeing their stocks sit, churn for a while, and not really move, but those confident in the prospects and in the valuation of a company will buy as these dips occur, thus ensuring a “base” when the stock falls back. They’re not “value” investors, but they’re investors believing that a company’s value sits at a certain price where they’d be willing to buy, again and again. But these stocks exhibit no such pattern – they don’t really come up for a breather at all, and sort of just simply keep going and going and going. So investors who get into these names, including but not exclusively hedge funds, are doing it and finding what Mike O’Rourke of JonesTrading called “instant gratification from price appreciation.” When investors talk about stocks going “parabolic,” that’s what they’re referring to – look at Netflix last year, rising with barely a stop from around $90 to more than $450 a share.
Volume and Volatility: This is an underappreciated aspect of the stock-price move, and that when you see these stocks start to take off, often volume will bust out in a big way on the up days as more and more people jump in to take advantage. They also tend to move around a lot.
Short Interest: Not always necessary, but often an added part of this. Just as these stocks often attract hungry buyers, there are a lot of hungry sellers who jump in as well and believe – as is likely the case – that the valuations are absurd. But with momentum stocks, that doesn’t really matter, so you see lots of shorts get burned. Green Mountain Coffee Roasters, Tesla, Netflix and a few others are good examples of those that built a stubborn short base for quite a while. Eventually, they will be right, but they may not even be in the stocks anymore, having gotten run over by big big mo.
Faddish Industries: Those that buy these names can either be emotionally connected to a story – prostate cancer drug maker Dendreon had for years a fervent group of followers who lived and died on every regulatory announcement – or they come out of brands that naturally attract buyers because they have a consumer appeal as well. Netflix, Priceline, TripAdvisor, or Tesla all work in this description. Sometimes they’re even an outlier in an otherwise slow-growing industry because of “fad” appeal – Crocs was a big momentum stock for a long time too.
So what’s all this make out as? The question is when people start to find value in these names, but given that tradition valuations don’t work (Netflix is valued at 20 times sales; the S&P is 1.7 times), investors start to see the upward momentum in these names sag, and then quickly exit as fast as they got in – Morgan Stanley points out that a basket of stocks consistent with hedge-fund overweights lagged a basket of HF underweights by 7.7 percentage points from March through April 4. There’s a point where these stocks become “broken” – and it can take several attempts before it happens, as it did in the dot-com era, but once it happens, there’s little real way to stop it. The average price paid by investors in a lot of these names ends up being higher than where the stock is at a given point, and that acts as a ceiling on a rebound. A few stocks escape this, but many don’t.