It’s Not About The Stock, It’s About The Story

I love listening to banter on StockTwits regarding high momentum names, and not only because that is the niche that I trade in.  There’s a reason that some assets exhibit high momentum relative to their universe, simply put, it’s because the market’s perception of their value is changing rapidly.  What usually drives a change in perception of value?  A change in the underlying business and its prospects.

Some of you may believe that traders who use technical analysis don’t care about fundamentals, you’re completely wrong.  Technical analysis is just the tool by which we manage risk and market time, it is by no means the way in which we judge which assets we should be looking at on a daily, weekly, or monthly basis.  The process by which I aggregate my watch lists starts with a fundamental screen, I don’t look through 3,000 charts and then go through the fundamentals for the best setups.  I screen a large universe of assets and then look for the best technical setups within the 200-350 stocks that come through.  I research these names, know their stories, understand what drives the stock.

Back to the StockTwits stream and momentum.  Big shifts in the perception of value and its effect on price produce differing opinions, often sharp differences.  Let’s just take NetFlix $NFLX for example.  There couldn’t be a wider gap between what the bears and the bulls feel this company is worth.  Why?  Because not many understand the business model, hell, NetFlix might not understand their business model yet, and that produces confusion and room for surprises, which in turn produce momentum in price.  Some believe that NetFlix is grossly overvalued, that its business model is not sustainable, that they may be cooking the books to some extent, etc.  Just take a look at the monster short ratio in the stock’s float.  There are a lot of people betting against this stock, and thus far, just about every single one of them have been wrong.  A stock showing great price momentum with a large short float equals a fundamental story that many don’t quite understand yet.

And this creates great conversation.  The bulls make their arguments about how quickly revenue is growing, the untapped market for their product, secular growth of the technology or service, etc.  The bears blast the stock as being one step from the cliff at all times.  The great part is, everyone is right, and wrong.  So far the bears have been completely wrong, every last one of them, because no matter what the fundamentals are, only price pays, and they’ve all lost money.  The bulls have been dead on, but many will be losers in the end as at some point NetFlix will retrace as its price to earnings ratio comes back in line with historical norms.  This will happen, I guarantee it, there’s not a stock in history that has stayed at this valuation level forever, it happens to every company.  When will it happen?  When the story is better understood by the market, that’s when.  What was Microsoft’s $MSFT price to earnings ratio in the early days?  What is it now?  There’s no secret to how this works guys, it’s a function of understanding the business model and being able to forecast growth.  Right now that’s not possible for NetFlix, it’s just not.

There’s another factor at play here as well, and it ties into what I just said.  Momentum in an asset’s price, especially one where the business model or specific situation is not known, is largely dependent on “the story”, not the specific fundamentals.  Oh yes, I said it, the price is not dependent on the fundamentals, everyone scream and run out of the theater.

Not to get too deep into my overall market philosophy here, but this is a very simple concept.  The price of an asset is solely dependent on its supply and demand. Yes, economics 101 does work for trading stocks.  I’m serious, at the end of the day that’s what it comes down to.  If more people want to buy an asset than are willing to sell it at a specific price, the price goes up.  And guess what, not everyone has the same model for what that asset should be valued at based on normal historical ratios, oh my god!  This is what creates a market, else none of us would come to work every day.

It’s often not about the stock itself, it’s about the story.  Let’s stick with the NetFlix example because we’re already deep into that one.  What’s the bullish story?  Streaming video content right?  People wanting to watch movies on demand, not have to go to the movie store, watch episodes of their favorite tv shows whenever they want.  People hate their cable companies for bundling a whole bunch of crap they don’t want to watch with the few things they do.  People are taking their media elsewhere besides the living room, they want it at the office, in the bedroom, at the airport.  The story here is streaming content, anywhere, anytime.

Now let me ask you this, how many other companies out there are doing this?  Maybe 2 or 3, at most, if you stretch it.  How many of those companies are public?  None that I know of.  Maybe put YouTube in that bucket, but it’s part of Google, and no one knows what it would trade for if it was spun off.

My point here, is that at the beginning of a large secular trend in a new industry or technology, there aren’t many players to choose from.  NetFlix stands alone right now as the only place you can get direct exposure to this play in the public markets.  Sure, there are a whole handful of derivative plays off of NetFlix, and they are going nuts right now as well.  But direct exposure to the story can only be found through that stock.  What do you think happens when every growth manager and mom/pop decides that they want exposure to this story.  Yes, they pile into one stock.  What’s the result, the stock goes up, and its valuation goes bizonkers.  Valuations only matter on the way down for new stories that people don’t understand!  No one cares that NetFlix trades at a 65 P/E, it just doesn’t matter.

But it will some day, when new competitors enter the market, or there’s more visibility regarding the growth potential for the company, or limit on that growth or market.  Think Under Armour $UA.  I remember in the middle of ’07 when Under Armour was the hottest stock that everyone wanted in the apparel space.  The story was great, but the valuations were very extended.  And then Nike $NKE entered the market, and that called the top.  We all knew it, and exited the position in client accounts.  All of the sudden the market had another company to focus on when it came to the next generation of athletic wear.  And the premium came rushing out.  Yes, prospects for the business had changed, but it was the story that had changed more, and that was the most important thing for the stock.

When you are trading momentum stocks, it’s far more important to focus on the story, and what the market perceives as the story, than it is to focus on the specific valuation metrics.  Learn to understand the company and its competitors, what the research desks think, what the short interest is, and what the nay sayers believe.

Both the bulls and bears are just about always right when it comes to momentum, it’s just a matter of how long it takes.  It’s my experience that only a tiny fraction of the bears will make money as they catch the top, while a greater portion of the bulls will catch pieces of the run up.  Still many bulls will lose on the way back down as they are only concerned with the bullish side of the story, learn to understand both and you won’t get caught in the falling elevator.

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