Posted by on Apr 14, 2014 in Blog, Columns |

By Jason Zweig | 7:34 pm ET  Apr. 11, 2014
Image Credit: Christophe Vorlet

When you pay too much for a dream stock, don’t be surprised if you end up with a nightmare.

Over the past year, investors became increasingly excited over the hot performance—and even hotter future—of industries like biotechnology, Internet retailing and social media. But the ferocious selloff in these stocks over the past few weeks should remind every investor of a basic rule: You can be absolutely right about the future and still get wiped out.

Correctly forecasting a company or industry’s potential for growth is important—but not overpaying matters even more.

As of March 18, when these sectors peaked, Internet retail stocks had gained an average of 88.9% over the previous 12 months; biotech stocks were up 65.7%, says Greg Swenson, a senior analyst at the Leuthold Group, a research and investment firm in Minneapolis.

At that point, Internet retailers traded at an average of 158 times their earnings over the previous 12 months and 5.7 times their revenues; biotech, 44 times earnings and 19 times revenues. The market overall was valued at 21 times earnings and 2.2 times revenues, Mr. Swenson says.

In general, the hotter a stock had been over the past year, the more expensive it had gotten—and the harder it has fallen.

No fewer than 10 biotech companies each traded for at least 1,000 times their revenues as of March 18, according to Mr. Swenson. (None of these firms yet had any earnings.)

Gina Moore, a portfolio manager and partner at AJO, an institutional asset manager in Philadelphia, calculates that 435 stocks, or nearly 15% of the Russell 3000 index of the U.S. market, were trading for at least 100 times the previous year’s earnings before the selloff of the past few weeks. Most were in biotech, social media or software.

A stock that doubles and then loses just 50% is right back where it started. No fewer than 18 highfliers have lost at least 50% from their peak so far this year, according to AJO—among them, biotech companies Halozyme Therapeutics (down 58% between Jan. 23 and its low this week) and NewLink Genetics (down 60% since Feb. 25).

There isn’t any doubt that the potential profits from breakthroughs in biotechnology are huge. Nor was there any doubt, back in 1999, that the Internet would boom—and, sure enough, it did. If you happened to buy, you ended up being right—and making a good investment. But if you bought just about anything else, from America Online or Exodus Communications to Lycos and VerticalNet, you ended up badly underperforming the rest of the stock market—even though the Internet grew just as explosively as you expected.

As the economist Max Winkler quipped in the late 1920s, investors often discount “not only the future but the hereafter”—meaning that the price they pay for their hopes is so high that they won’t make any money even if their hopes are realized.

For many people, the sight of stocks doubling and tripling or more in a matter of weeks is too great to resist. But in order for a stock to possess “momentum,” as defined by academic researchers and leading investment firms, it needs to have been going up faster than average over the past two to 12 months or so. If it has been on fire for just a few days or weeks, there’s no reason to believe its hot returns will persist, experts say.

And the cheapest stocks with momentum do the best.

When you hold speculative stocks at ultrahigh prices, you either win big or lose big, says Ms. Moore of AJO. “This is investing with 1s and 0s,” she says. “It’s on or off here.”

That is why diversification is so important. If you can’t resist the urge to chase fast-moving stocks, then you must hold cheap ones as well. “Momentum and value tend to diversify each other, going through good times and bad times at different times,” says Ronen Israel, a principal at AQR Capital Management in Greenwich, Conn., an asset manager that invests about $100 billion.

If you steer clear of hope stocks, you can even use momentum “as a signal not to trade,” says Jed Fogdall, co-head of portfolio management at Dimensional Fund Advisors in Austin, Texas, which manages more than $338 billion.

Studies of individual investors show that the stocks they buy perform worse than the ones they sell—almost certainly because investors buy too soon (before a falling price can make a stock even cheaper) and sell too early (while the price is still likely to continue rising).

In fact, according to extensive academic research, stocks that have been rising for several months tend to keep going up for several more, while those that have been falling for several months tend to keep dropping.

So—as long as your recent winners remain reasonably valued—you should wait to sell, since momentum is likely to carry them higher for a while longer.

By the same token, you can be patient in buying recent losers; let their recent downward momentum turn them into even greater bargains before you buy.

That way, “you’re not incurring trades because of momentum,” says Gerard O’Reilly, head of research at Dimensional. “You’re delaying trades because of it.”

In short, hope is rarely underpriced on the stock market. The more you pay and the faster you rush to get it, the less you will end up with in the end.


Source: The Wall Street Journal