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Momentum stocks consist of fast-growing companies with a particularly high level of optimism surrounding its future. These stocks can sometimes post gains of 300% or more in just a few short years with extreme growth and promise of more growth ahead. However, sooner or later, these stocks bust and trade lower when its fast growth subsides or the high optimism shifts to pessimism.

The two best examples are Green Mountain Coffee Roasters (NASDAQ:GMCR) and Netflix (NASDAQ:NFLX) which have both lost substantial value over the last three months after optimism shifted to pessimism regarding future performance. Therefore let's take a look at the fundamentals of these two stocks to determine what caused such loss and then look at four additional companies to determine whether or not they can expect similar loss in the near future.

To better understand how fast growing stocks can reverse let's look at both GMCR and NFLX's fundamental performance during its most recent quarter along with stock performance.

Stock Performance and Earnings

Company Ticker 3 Month Performance Q3 Revenue (millions)

Year over Year

Q3 EPS Year over Year
Netflix NFLX (65%) $821.84 48% $1.16 69%
Green Mountain Coffee Roasters GMCR (48%) $711.88 91% $0.42 160%

The two most important factors of a publicly traded company are the top- and bottom-line numbers and how it relates to expectations. And if you look at both numbers for GMCR and NFLX you will see significant progress year-over-year, in fact both companies posted record earnings for Q3. However, both stocks lost a large amount of value regardless of strong earnings that each company posted during Q3.

The issues with GMCR and NFLX isn't the fundamental progress, it's the perception among investors who believe the companies outlook has become dim. This change in the companies outlook has negatively affected these two stocks which were trading high above earnings. Netflix lost the majority of its value after announcing that it was increasing prices; therefore investors sold in fear that its earnings would suffer. However, if we look at the company's earnings, we would see that margins actually increased by a significant amount and the company posted the best quarter of its history.

Green Mountain's loss came after David Einhorn gave discouraging opinions regarding its accounting practices and its supplies, which caused fear that earnings would disappoint. Yet much like NFLX the company's earnings were strong compared to the same period last year. Therefore the fall of these two stocks weren't a result of decreased earnings, but rather fear that earnings could decline in the future.

When momentum stocks fall, it doesn't necessarily mean that the company is a bad investment. It simply means that the stock is better priced for value and that it has less chance to fall in the immediate future, if the company can maintain earnings. And with GMCR and NFLX falling so fast investors must be concerned of other stocks that trade high above earnings. Therefore let's take a look at five stocks that are trading high above earnings and compare earnings with several metrics to determine whether or not these five stocks could become the next momentum stock to post large loss.

Momentum Stocks' Earnings

Company Ticker 5 Year Performance Q3 Revenue Year over Year EPS Year over Year
Alexion Pharmaceuticals (NASDAQ:ALXN) 522% $204.05 45% $0.34 123%
Amazon (NASDAQ:AMZN) 447% $10,876 44% $0.14 (72%)
Salesforce (NYSE:CRM) 218% $546 38% ($0.03) N/A
Red Hat (NYSE:RHT) 195% $281.32 29% $0.20 67%
Lululemon Athletica (NASDAQ:LULU) 275% $212.32 38% $0.26 74%

Each of these companies has posted incredible revenue growth year-over-year; however, only ALXN, RHT, and LULU have increased earnings and margins during the last quarter. Therefore an investor may assume that these stocks will continue trending higher, and that AMZN, which declined profit margins by a mind-boggling amount, and CRM, which posted a loss, would be the two stocks most likely to lose momentum. However, if you look at GMCR and NFLX, both stocks grew much more aggressively than any of the stocks on this list, and each trended lower. Therefore there is more to the story than just earnings to determine whether or not a momentum stock will trend lower, which means we need more data. Below is each of the stock's market cap, P/E ratio, forward P/E ratio, and the book value per share for each company.

Ticker Market Cap P/E ratio Forward P/E Book Value Per Share Stock Price
ALXN $12.40 B 83.24 39.2 5.70 $66.88
AMZN $97.64 B 97.64 104.96 17.07 $215
CRM $18.09 B 660.14 75.42 10.47 $133
RHT $10.17 B 78.65 45.70 7.06 52.65
LULU $6.62 B 49.86 36.33 3.46 $52.28

After looking at both charts, we can now better determine which stock may lose momentum in the near future. Each of the stocks trade with high above earnings, yet Salesforce is on a different level. But it, along with ALXN, RHT, and LULU, has a lower forward P/E ratio, which means earnings are expected to rise.

The only stock with a higher forward P/E ratio is Amazon, because of its declining margins year-over-year. LULU is trading the highest compared to book value per share, while Red Hat is trading lowest. Therefore, as we have seen each and every one of these stocks have several warning signs that could indicate loss in the future.

I believe that ALXN, RHT, and LULU are the safest investment of the five stocks with an unlikely chance of trending lower in the near future. ALXN and RHT both trade high above earnings; however, both stocks are expected to post much higher earnings next year resulting in improved trading metrics. All three of these companies have done a great job at cutting costs and improving margins therefore I expect for these three stocks to continue trending higher assuming that fundamentals continue to improve at the expected rates.

Salesforce is a stock that has been on the downward trend watch list over the last month, since NFLX and GMCR trended lower. Several analysts have predicted that CRM will be the next momentum stock to fall, and I believe it's very likely. The company posted a net loss during its most recent earnings report, has horrible margins, and returns very little on its assets and equity.

Analysts are expecting a forward P/E of 75.42, which would mean the company would have to make major improvements. But I don't believe it's possible: Tthe company has a history of low margins, and considering that margins are declining, I don't foresee a high level of improvements. The company will have to miss expectations at some point in the future, and when it does, it could be catastrophic for the stock.

Amazon posts incredible revenue and is growing in usage, therefore I don't believe its chances of loss are lower than Salesforce. However, I believe the stock is reaching the top of its range, with a 447% gain over the last five years and a $97 billion market cap on less than a billion dollars of income. The company is expected to post lower earnings in 2012, and I expect that because of its declining margins the company will fall short of bottom line expectations quite often. And although I understand the hype surrounding the stock and believe it's a great company, I believe the downside is far greater than the upside, and that investors will be able to purchase this stock at half price within a year from now.

The truth is that both NFLX and GMCR show better growth than any of the five stocks on this list, yet both trended substantially lower. And since there is no way to predict which, if any, of these momentum stocks will fall investors must be cautious and learn from previous experiences with NFLX and GMCR. Both AMZN and CRM are showing signs of long-term cost cutting issues and I believe either could fall because of fundamental issues.

The only problem is that momentum stocks don't need declining fundamentals to lose 50% of their value; all it takes is a rumor or a downgrade and a fast growing stock can trend much lower. And in this economy, where volatility is at its highest, I don't feel comfortable investing in any stock that trades particularly high above earnings, regardless of its potential.

If you look at the top 20 largest stocks in the market, none of them trade at 50x earnings. Therefore, if you like a momentum stock and believe it has a large amount of upside, then wait for it to fall, because history tells us it most definitely will fall at some point, and assuming that fundamentals are continuing to grow, then it will make a great long-term investment. And you will be able to ride the stock higher with much improved trading metrics.

Disclaimer: As with any investment, due diligence is required. The opinions in this article are not intended to be used to make a particular investment or follow a particular strategy but rather informational purposes only.

Source: 5 Momentum Stocks That Could Fall Victim To Negative Sentiment