The Risk Of Momentum Stocks

by: Wim Dankbaar

Let's look at the risk of momentum stocks like Netflix (NASDAQ:NFLX), Opentable (NASDAQ:OPEN), Travelzoo (NASDAQ:TZOO) and (NYSE:CRM).

I don't think anyone will argue that isn't a momentum stock. With a Price/Earnings ratio north of 500 and a Price/Sales ratio of 8, boasting a market capitalization of 16 Billion dollars, it is one of the most chased large cap stocks on Wall Street.

The characteristic of a momo stock is that it attracts more buyers, just because just keeps going up in price, thereby disconnecting itself from the underlying fundamentals, like PE, PS, book value, etc.

People are buying because other people are buying, and because they want to miss a piece of the pie. Of course this process is often helped by media hype, and analysts who keep claiming the stock remains attractive with upside potential. Knowledgeable value investors do not see a sensible reason why the stock keeps rising, as they take the value ratios as a measure to buy or not buy.

The phenomenon is depicted rather well in this cartoon clip.

However, the opposite is true when a momo stock loses its momentum. The result is a total collapse, like we are witnessing for Netflix, Opentable, Travelzoo, etcetera.

People are now selling because other people are selling, and because there is no rational reason to hold because of valuation, just like there was no rational reason to buy when the stock went up. Greed has made place for fear. The media and the analysts that were marveling the stock and its growth story on the way up, now join the bandwagon to tell you to sell. Where there seemed no limit on the way up, there appears to be no bottom on the way down. The way down is normally much steeper than the way up. Where the way up took a few years, the way down is usually a few weeks or months. Just look at the charts of OPEN and NFLX or this example.

I see CRM as a classic momentum stock, that has just turned the corner. Even more a momentum stock than NLFX, OPEN and TZOO if you look at valuation. It could well be on the verge of breaking down, with steep declines ahead.

Disclosure: I am short CRM.