One of the classic momentum stocks of the last year and a half has been Green Mountain Coffee Roasters (GMCR). In my opinion, this is a great company with a great product. However, it is also true that the company's stock is almost completely detached from the underlying fundamentals (The stock had been trading at 9X sales and 110 X P/E at its peak).
The GMCR stock is a classic case-study for investing in momentum stocks, and therefore I decided to write a couple of articles analyzing it. The stock has gone through both the boom and bust stages of a classic momentum stock. Therefore, understanding it better might be useful in deciphering this interesting investment style better.
I will devote this article to explaining the investor types dominant in the market and how the momentum stocks fit in that context. I will then try to answer the question whether GMCR still keeps its momentum status and I will try to explore the reasons.
Equity markets are full of investors with a variety of income and capital appreciation objectives. However within this variety, two classes of investors make up a huge percentage of the pool. These are the value investors and growth investors. These two groups have almost the exact opposite preferences in a stock although they compete in the same arena. Value investors are basically stability hunters. In my opinion, they informally look for the following attributes in a stock:
- The valuation should make sense on a discounted cash flow basis. The value should lie in the already established earnings power not the future growth. Earnings yield should be high. This eliminates pretty much all the companies above a 10 P/E.
- The earnings of the company should be stable. There shouldn't be fluctuations due to the nature of the business the company is in. This is why commodity producers like CF Industries (CF), Freeport McMoran (FCX), BHP Billiton (BHP) don't make the cut with value investors although they trade at very reasonable valuations. The volatile nature of the commodity markets make those companies too unstable for value investors.
- Dividends are almost a must. Value investors buy the company for the earnings yield. They don't like it if the company decides to keep the money to itself. Also a stable dividend stream is the ultimate proof that the company is making money in real life, not just on paper.
Before jumping on to the growth investors, I will make a rather controversial assumption here. I will assume that the growth investors and the momentum investors are basically the same. I admit that there are some truly remarkable and pure growth investors out there. However, the ability to spot an innovative product or a unique business model before it gets hyped up in the investor arena is a very rare talent. The people who have that talent are so far in between that it is a reasonable assumption to make that almost all the remaining growth investors are in essence momentum chasers. Growth investing has essentially become a nice cover to justify the baffling valuations involved with momentum stocks.
The majority of the characteristics that momentum investors look for in a stock serve a single purpose and that is the stock should be immune to attacks on its inexplicable valuation. The continual rise of the momentum stock is mostly a result that short sellers fail in their attempts to bring down the valuation multiples and they are forced to cover. To accomplish that, the stock should trade at a high multiple for an extended period and as a result should make the critics question their assumptions.
The attributes that momentum investors look for, in my opinion are:
- The company should be in a relatively new industry or be in a completely unique business. The idea is that there should be no other established comparable or benchmark to compare the valuation to. In turn, it should reinforce the idea that the valuation is so high because there is something really unique about the company. This is the main idea that supports the cloud stocks like F5 Networks (FFIV), Salesforce (CRM), NetSuite (N), RedHat (RHT) and others like Amazon (AMZN) or Lululemon (LULU). It is argued that since this industry is so new, the critics are wrong in comparing it to other business models and sectors.
- The story should be all about the revenue growth. Profitability should be almost completely ignored. The idea is that many momentum stocks are just impossible to justify on a P/E or EV/EBITDA basis. Also, accomplishing profitability is an order of magnitude more difficult than accomplishing revenue growth. Therefore, the momentum investor shifts the attention from profitability to revenues to defend the stock from attacks on its valuation. Also a 6X Price to Sales multiple is more presentable than a 110X P/E multiple.
- There should be a very strong uptrend in the stock price AND the valuation multiples. This is very important. Momentum investors, above all, are trend followers. Any sign that the trend is being challenged or the multiples are getting compressed and the momentum investors leave in flocks. This is what brings the end of most momentum stocks, including GMCR. You should note that momentum stocks are way overvalued based on profitability measures. Any sign that the company can no longer justify its low profitability on future growth prospects suddenly crashes the multiples, brings back the valuation to normal levels and as a result, crashes the price.
The characteristics above should make it clear that GMCR is a classic momentum stock. It had a unique product and a unique business model, it was way overvalued and it had a very strong upward trend.
Well, until August 2011 that was. A series of events knocked the stock off its price trend which brought about the end of GMCR as a momentum stock. Here is what happened and why it happened:
- The stock got a huge hit in the market swoon of August 2011. The stock had already jumped recently on its earnings results. The decline was limited to giving back those gains. Also it is not unusual for high-beta stocks to get hit when market unexpectedly turns. GMCR quickly gained back its losses after the steep decline in the markets stopped. This made it keep its momentum stock status. Also it managed to get back to its previous price trend.
- In September 2011 and October 2011, things started to change. The price started deviate from its upward trend despite a flurry of analyst upgrades. The price first rapidly declined from its peak of $115 to around $90. Then in October 2011 an influential hedge fund manager, David Einhorn, attacked the company's financials and whether its growth plans will justify the valuation. As mentioned, the single worst thing that can happen to a momentum stock is that its fundamentals are brought into attention, no matter how good they are. Because the valuation is so high no matter how good the company is executing its growth plans, once the valuation starts to get attention that is usually the end of the road.
- It is also important to note that before the David Einhorn report, the stock had already gone off its upward trend and had broken down to the downside. It is really up for debate whether David Einhorn attacked the stock because of its fundamentals or he just foresaw that the stock was starting to crash and took advantage of it to make a good prediction. I would go with the former. Once the trend breaks, usually analyst reports and the like are mere justifications for the fact that the stock "is not working anymore".
- In the following months after the Einhorn report, GMCR started to come under even further scrutiny. It is very telling that, the accusations thrown at the stock (the patent expiration, and that competing products from big pocketed competitors were on the way) were very much obvious even before the stock lost almost half its value. It just shows you that momentum investing is all about the trend. If the trend is intact, it's all about how the critiques don't understand the real story behind the stock. Once the trend is broken, investors mysteriously open up to all the critiques.
- After the swoon, the stock stabilized around $50. The fact that the stock failed to participate in the huge market upside since October 2011 just proves that momentum stocks just don't recover their status once they are broken. The only way to get back to their previous heyday is if the company really grows into the valuation.
So the question is should you short GMCR? Or should you just try to participate in more modest upsides from the $55 level since the company still has a great product and a successful growth plan.
The simple answer is, due to the reasons given above, GMCR will probably never reclaim its peak of $115 and will never regain its status as a momentum stock. So if you are expecting that kind of an upside you should stay away.
The main problem with the stock, as of this writing, is that valuation is still not low enough to entice the value investors. The stock trades at roughly 2X Sales and 26X P/E. However, the price action is also not good enough to lure back the growth investors. Not many investors like a stock that is neither here nor there. And that seems to be the exact situation that GMCR finds itself in.
However, to answer the question of whether there are further price crashes down the road, or there is some modest upside to the stock. I will look at some other sectors and stocks that have gone through the same momentum boom and bust pattern. It will be the subject of my next article on GMCR. I will argue that there is probably another correction down the road.