- OUR VIEW
- LEARNING CENTER
What do you do when a stock you own, or want to own, suddenly becomes disconnected? It's very important in this market to clearly understand whether a stock's price movement is being driven by momentum players, or by investment players. If you step into a stock using the wrong premise, you may find yourself wondering what happened to your money a month later.
Investing in a company's stock because you believe its business future is good is based on the premise that the stock price is related to the company's business. But in the past few years, there have been many stocks whose price wasn't related to business prospects. Briefing.com calls these "disconnected" stocks. The stocks become disconnected when "fashion" investors descend upon them.
Fashion investing requires no analysis of the company's underlying business prospects, current or future. All it requires is knowledge of what is fashionable, or soon to be fashionable.
But often, when the momentum leaves a disconnected stock, the price falls all the way back to where it started, or lower. The fall usually takes longer than the rise, but the wealth is lost just the same.
What is an "investor" to do when a stock becomes disconnected?
Here is an examination of all of the possibilities followed by a table summarizing the possibilities at the end of the article.
The best of all worlds.
You invested in a stock on an investing premise, and the stock becomes disconnected, and takes off.
In this case, you need to decide whether the stock price represents the full value of the fulfillment of the investment premise. Has it reached its "true" price prematurely, without having to actually fulfill the business promise?
If so, you either need to sell the stock, or change your premise.
There are a lot of stocks that have done this. Some went right past the "full value" of their investment premise, tripling their revenues, but still having lower stock prices.
Don't assume that the stock will continue to rise from the current disconnected level based on the company fulfilling its business promise.
If you want to continue to hold the stock, based on a momentum premise, that's fine. But make sure you're clear in your mind about your new objective.
The most annoying possibility.
You were thinking about buying a stock as good investment vehicle, either on a value of growth basis, or a turnaround basis, or other premise based on future business growth.
Suddenly, without any new progress on the business front, the stock triples or more, before you established a position. Now what?
The first thing you have to do is determine how much of the investing premise has already been fulfilled in the stock price.
For example, if you thought the company might double sales in the coming year, but it has already doubled in price, was your investment premise already fulfilled? If it was, you should just pass on the stock. Can't win them all.
If only a portion of the investment premise was fulfilled, then it may still be worth it. However, you now need to add the risk of "momentum players exiting" to the risk of the company not fulfilling its business plan.
In the partial fulfillment situation, a gradual entry into the stock is best. You protect yourself, or the bulk of your capital, against the sudden devastation that hits a stock when momentum players leave.
If the stock does continue to rise, more gradually or on lower volume, after the momentum rush, and after you make your partial entry, don't kick yourself for not putting it all in. It means that your investing premise is being perceived by others. That's a good sign.
And if the stock continues to rise rapidly without news, you are then in Scenario A.
This scenario is all too common.
Entry into the stock has already been made, because it was a "hot" stock, and then you do the research to back up an investment premise.
Alas, after doing the investment research, you can hardly believe the stock ran up to its current level. They don't have sales, or it turns out to be an unproven concept, etc.
The minute you find this out, you need to make a decision: Will momentum carry it higher? And do you want a momentum play? If not, you need to exit, even if it means a loss. Chalk it up to experience.
After all, the reason momentum plays decline gradually is that buyers at the top are reluctant, to varying degrees, to take a loss. Some exit early, others later, at lower prices.
This type of investor is exactly who the momentum players want to come in at the top, and take all the shares off their hands. Some even look for signs of increased "investors" in chat rooms as a sign the party is over.
You read about a stock that skyrockets, perhaps in a single day. Should you jump in now?
To answer this, you need to clearly separate whether you want an investment or a momentum play. If you want an investment, you need to complete an investment analysis. This includes answering the following types of questions:
XING is a good example here. This little stock skyrocketed from $8 to $52 in one day during December 1999.
News media everywhere reported that this happened because the company would now manufacture CDMA handsets in China.
But we doubt any new buyer of this stock had done much investment analysis, or at least, did it quickly. It was momentum driven. The business related announcement was only the spark that ignited the mo-mo move.
As proof, ask a XING investor how many other companies also have filed applications with the Chinese government for approval to build CDMA handsets. We're willing to bet that they don't know.
The momentum investors won't even care. That's okay, for a momentum premise but horrible for an investment premise.
Don't jump into a momentum stock you just heard about, on an investment premise, without doing the investment research first. If the stock takes off more before you finish, let it go.
The principle thought to remember is this: when a stock becomes disconnected, the stock price moves out of sync with underlying business prospects. Analyzing the business prospects of the company then becomes of secondary importance.
You can't assume that because a company has a bright business future that the stock will eventually rise from its current level, whatever it is.
All of the preceding words can be summarized in the following table.
|Action||On Investment Premise||On Momentum Premise|
|Entering before stock becomes disconnected||Just luck, be thankful, but exit when your investing premise has been reached, or make clear mind-shift to momentum premise.||Dumb, why wait around for action?|
|Entering after stock becomes disconnected||At best risky, at worst dumb.||Okay, but play by momentum rules.|
|Looking for stock that might become disconnected, and has investment premise||Good, but they are few. Most have been IPOs.||Not worth the effort. Wait until the action starts. Who cares about the business?|
The message is simple: be clear on whether you are taking a position on an investment premise, or a momentum premise. Confusing the two is the primary way people lose money on disconnected stocks.
Robert V. Green