As humans, investors have two states of mind, the emotional and the rational.
When in the rational state of mind, investors decide by reason, by taking a close look at the economic fundamentals of different assets. When in the emotional state of mind, investors decide by hype and impulse, chasing after assets, just by copying and imitating the moves of other investors.
Momentum investing is a strategy based on hype about an investment theme, a new product or a new industry that captures and captivates the investor mind - at times when money is cheap and markets are in an uptrend. In the late 1990s, the theme was telecommunications and networking, with momentum funds flowing into companies like Cisco Systems (NASDAQ:CSCO), Ciena Corp (CIEN), JDS Uniphase (NASDAQ:JDSU), Corning (NYSE:GLW) and Ariba Inc. (NASDAQ:ARBA). Now the theme is social media and web-based companies like Netflix (NASDAQ:NFLX), OpenTable Inc. (NASDAQ:OPEN), LinkedIn Corp. (NYSE:LNKD), Youku.com Inc. (NYSE:YOKU), Sina Corporation (NASDAQ:SINA), Baidu, Inc. (NASDAQ:BIDU) and Sohu.com Inc. (NASDAQ:SOHU).
Sometimes, investment hype is supported and re-enforced by solid economic fundamentals. Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG), for instance, could be considered momentum stocks, as they are at the forefront of computer and mobile technologies (Apple), and social media and search engines (Google). Both companies, however, are highly profitable as they enjoy a sustainable competitive advantage, due to some sort of proprietary technology that constrains entry of new competitors to their core business.
Other times, momentum trade is supported by weak economic fundamentals - if any. Netflix hype, for instance, isn’t supported by solid economic fundamentals. Though the company is highly profitable, it doesn’t enjoy barriers to entry to its business. The same is also true for OpenTable, which reported disappointing earnings last week.
Momentum investing can be very rewarding as long as it lasts. But it can result in hefty losses once it fades away or worse turns in the wrong direction, especially for investors who got in at the top. But what causes such a shift in momentum?
A number of factors: First, the unveiling of an accounting irregularity, as was the case with Enron in the early 2000s, and most recently with some Chinese stocks listed on U.S. exchanges. Second, a major top or bottom-line disappointment, as was the case with OpenTable. Third, a sharp increase in interest rates that raises the cost of margin borrowing, as was the case in the early 2000s - a factor that caused the burst of the dot.com bubble. Fifth, a major market correction that causes a sale contagion, as trades strive to raise cash to cover margin calls, selling the good, the bad, and the ugly, as has been the case in the current correction. So what should investors do? Should they buy or sell or avoid momentum stocks?
It depends on which category different momentum stocks belong. Investors should avoid or even sell momentum stocks with weak economic fundamentals like OpenTable and Netflix that do not have a sustainable competitive advantage. They do not have strong barriers to protect their business from competition, and are at the mercy of content providers who have the upper hand in negotiating content prices. But they should consider buying momentum stocks with solid economic fundamentals like Apple and Google. Apple, for instance, is an innovation and branding machine, with its own proprietary technologies that are hard for the competition to copy and replicate. Google has its own well-established search engine that is also hard for any other company to replicate, and the same is true for its Android phone.
The bottom line: Investors should consider buying momentum stocks with solid economic fundamentals, but stay away or even sell momentum stocks with weak economic fundamentals.
Additional disclosure: I'm short on NFLX