Whether you realize it or not, every growth stock of the last 20 years has experienced the exact same cyclical pattern. Now before you stop reading, I’m not talking about technical analysis or some other chart reading garbage.
The reason this cyclical price pattern continues to occur is fundamental and actually quite simple. You just need to understand that stocks go through five distinct phases.
Before I explain those phases, take a look at some of the fastest growing stocks of this century. Notice a pattern?
Not seeing it? You’re probably looking too hard.
Every one of these stocks, at some point in their early stages, experienced a meteoric rise in price followed by a plummeting crash.
Every one of these companies was the darling of Wall Street at one point in time.
Every one of them was wildly recommended by teams of bullish analysts.
Every one of them traded up to insane prices by any reasonable standard of valuation.
And every one of them suffered huge losses when the music finally stopped – most more than 90%.
So Why Does This Happen?
And more importantly, how can you avoid being the sucker holding a bag of the year's biggest losers? Easy... understand the cycle.
Phase 1 – Startup
The startup phase of a company is the riskiest time to invest. This is when a firm is trying to prove that its concept works and the model can be replicated. Think of Steve Jobs building motherboards in his garage or Michael Dell selling computers from his dorm room. These two examples turned out to be hugely successful, but for every Steve Jobs there are 10,000 Joe Nobodys who now work middle management at the local paper company.
Phase 2 – Growth
This is the most exciting phase of a stock’s life, and the one that almost every investor tries to capture. Once a company has proven its business model and is now publicly traded, it experiences sales growth at rates far beyond that of the overall market. It is not uncommon to see new enterprises growing in excess of 50% per year. The stock gains several hundred if not thousand percent and everyone from Main Street to Wall Street wants a piece of the action.
Adding to the growing company metrics is the fact that stocks in their growth phase trade at very different valuations from other companies. A small stock growing revenues at 35% annually will easily trade for 30, 50 even 100 times earnings. Meanwhile, Wal-Mart (WMT) and the other mega cap behemoths hold steady at multiples closer to 15.
And this is fine, for the most part. As investors we realize that stocks offering more upside potential over a shorter period of time are worth the premium earnings multiple.
But here is where everyone makes the biggest mistake. This is why your friend down the street gave up on the stock market after the hot IPO tip from his work buddy cost him 20 grand.
High earnings multiples are only justified as long as the company is growing at or above its previous growth rate. As soon as that hot new issue grows 20% one year instead of the forecast 35%, its valuation changes drastically. Instead of being priced at 40 times earnings it will likely fall to a price equal to about 20 times. This fact alone can crush the share price by 50% or more.
Legendary investor Peter Lynch was famous for buying stocks in their early stages of growth. In his book, One Up on Wall Street, he even laid out a wishlist for what called 'the perfect growth stock." Unlike most amateur stock pickers, he wanted a boring company in a non-growth industry with low institutional ownership and little or no analyst coverage. This is in stark contrast to the popular growth stocks of today like Tesla, Stratasys and Amazon. None of these high flyers would have come close to meeting Lynch's investment criteria and all of them will likely lead to stiff losses for late investors. Try the Peter Lynch scan in the GuruFocus All-In-One Screener.
Phase 3 – The Stall
The stall is a very brief, yet very important moment for growth investors.
Maybe revenue did not grow at the meteoric rate Wall Street was expecting. Maybe its hot new product has lost its appeal with consumers and earnings are beginning to suffer (remember Crocs sandals?) Maybe it got cocky and launched a new product or service that wasn’t met with the success it was expecting. Or perhaps a macroeconomic factor such as a recession or commodity shortage has inhibited its ability to grow.
For whatever reason, the stock shows a chink in its armor.
The stock that was once believed to be incapable of disappointment has now become “speculative” in the eyes of investors. That which was once thought to be a sure thing has suddenly revealed the inherent risk lying beneath its ticker.
The last two months have seen many rocket stocks begin to stall - YELP, DDD and LNKD to name a few.]
This is undoubtedly the most difficult phase to spot when it happens, primarily because of the wide range of causes. Using GuruFocus's Interactive Chart feature, let's take a look at a few from the stocks mentioned previously:
Many investors tried to blame Blackberry's (NASDAQ:BBRY) decline on the 2008 recession, but we can clearly see that this was only a blip on the radar. The real selloff began in mid 2009 after the markets had stabalized. Notice that revenue (blue line) and net income (red line) were still growing when the stock price (green line) began to collapse. Rumors of new products from Apple and other competitors put fear into BBRY stockholders who suddenly began to revaluate the multiple they were paying for the stock.
This is Amazon (AMZN). While it may look like a minor pullback in hindsight, shares of Amazon lost more than 90% in the 18 months follow its stall. While the company has never been very strong in terms of earnings, the stock price (green) has for the most part climbed lock stock and barrel with company revenues (blue). But when shares traded well in excess of this figure as seen in the GuruFocus Interactive Chart, shares plummeted back to reality in the ensuing revaluation.
First Solar (NASDAQ:FSLR) is very similar to Blackberry (NASDAQ:BBRY) in that revenue (blue) and earnings (red) were still growing when shares began to stall. While the economic recession no doubt played a part, I believe it to have been more of a catalyst than a cause. For no black and white reason that could have been found in the company's financials, investors simply lost faith and realized that valuation was out of hand.
You'll find the same pattern in almost every explosive growth stock of the last two decades. Overly optimistic investors, having no understanding of the concept of valuation, bid shares up to prices that cannot be justified.
Phase 4 – Revaluation
The stall is generally indicative of the end of the company’s growth phase. While there are exceptions (Apple among them), most stocks are harshly revalued at this stage of their life. The euphoric speculation and optimistic investors from the growth phase have set them up for an unavoidable collapse in price.
And now that record-breaking growth is no longer assumed, share prices fall in line with those of similar, more stable competitors. P/Es of 50 and 100 become 10s and 20s. That $2.00 earnings per share figure no longer justifies a $125 stock but one closer $30 instead.
The severity of the ensuing collapse depends largely on the ridiculousness of growth stage bullishness. In Peter Lynch’s day, the most optimistic new IPO would be hard pressed to reach a price in excess of 30 to 40 times earnings. Today, many hot stocks reach P/E levels well in excess of 100.
Take First Solar (NASDAQ:FSLR) for example. In 2007 this was believed to be the company that would solve the U.S. energy crisis. Solar was the wave of the future and the stock received heavy buy recommendations across the board. In May 2008 shares hit $300 – a price equal to 147 times prior-year earnings.
This was the peak of the growth phase for First Solar. Even skyrocketing gasoline prices and a new democratic president couldn’t justify the ludicrous P/E ratio. Shares fell by more than 60% over the next 12 months, even though company earnings more than doubled during the same period!
First Solar was a cult stock – one retail and individual investors alike were fighting to own. And for a while, no price was too high. This was a “Shut up and take my money” stock if there ever was one (think Tesla today).
But once the revaluation took place it was a domino effect of crushing blows. The P/E ratio of 143 left a long way to fall before shares were again perceived as attractive. Short-sellers piled on (as they always do) and exacerbated the sell-off.
Not only did First Solar come down to fair value, it actually fell well below it. Competition from Chinese competitors sent consumer sentiment to new lows and shares trade below $12 in mid-2012 – a loss of more than 96% from its $311 peak.
Phase 5 – Recovery
This is the final phase of the cycle and where I generally look to invest. Now that the overvaluation and ensuing correction (or overcorrection) has taken place, the stock joins thousands of peers who have already experienced the same process. It is now a “mature” company and will be valued accordingly. If they have been able to show stable and consistent earnings, they should gravitate toward the high end of the P/E and P/B multiples of their respective industry. If they have been somewhat less consistent and are plagued with fluctuating gains and losses, they will likely be priced at the lower end of the same spectrum.
My favorite stocks are those that have proven their business model, grown responsibly without the need to take on debt or dilute shareholders, but still fallen victim to the cyclical over/under valuation game. If the correction has been severe, these stocks often become mispriced and are offered at below average valuations.
Let’s look at First Solar (NASDAQ:FSLR) again. At its June 2012 low of $11.77, it traded for less than 3 times average annual earnings over the last five years.
I was a little bit late to the party and picked up at position at $37 last September, but I’ve still done reasonably well. Shares are up another 88% at the time of this writing.
Blackberry (NASDAQ:BBRY) was another example of overcorrection. The crushing selloff resulting from their loss of market share sent the stock below tangible book value. I went long in August of 2012 at $7 a share and flipped it out at $14 five months later. This was a classic Ben Graham net-net you could have worked out with third grade math skills.
What about Crocs (CROX)? I wouldn't be caught dead in those rubber shoes, but I'm happy to squeeze some profits from the stock. 2007-08 was a blistering period for shareholders but the $1.06 low was a gimme for value hunters. The company held zero debt so bankruptcy wasn't even a concern. The chart above is referred to as the "Peter Lynch chart" which graphs the share price (green) against the earnings line (blue) - a hypothetical stock price at 15 times earnings. A 4-year-old could have spotted the gap there and savvy buyers grabbed a 26 bagger from low to high.
The takeaways I hope to deliver in this article are twofold – part warning and part opportunity.
Warning: The growth phase can be both the most rewarding and the most painful time for any stock. If you wish to try your hand at fast growers, you MUST remain focused on valuation. A good rule of thumb is never to pay an earnings multiple higher than the company’s growth rate. This will prevent you from being dealt the blow of harsh revaluation from speculator euphoria. Focus on companies that are profitable now, not those that expect to be in several years *cough* Tesla *cough*cough*.
Look at the four charts below (LNKD, YELP, SSYS, TSLA). These are some of the highest flying stocks of the recent bull market. Five years from now, I expect each of their charts to look like the 6 at the beginning of this article. They are all near the peak of their growth cycle, trading at unheard of valuations, and poised for a crash that will no doubt take unsavvy investors by surprise.
Are these bad companies? Absolutely not. The issue is simply price.
The stock market is the only component of our lives where people pay little to no attention to price. If I tried to sell you a $90 gallon of milk or a $300,000 minivan you would scoff. That's unheard of - who would pay such a ridiculous price? Yet paying $203 per share for a car company that has lost money each and every year since inception is "investing" (yeah, I'm talking about you Tesla).
If you're wondering how to predict these stalls, I'd invest in a crystal ball. Nothing else has seemed to work. While it is relatively easy to spot an overpriced stock, pinpointing the moment that investors will face the reality of the absurd stock price is all but impossible. My advice is to wait for the inevitable Revaluation and shop for deals on the downside.
Opportunity: Stocks reaching the end of their revaluation phase can be some of the best buys in the market. Buying them on the way down can be like trying to catch a falling knife, so focus on valuation and wait for the stock to be offered at a 50% discount to your fair value estimate. If it keeps falling, keep buying.
If they are still issuing new shares, accumulating debt, or showing consistent losses - move on. Good businesses are profitable even at a small size. They don’t dilute shareholders through additional offerings and they don’t need to borrow cash to keep the doors open. They should be able to stand on their own two feet. Otherwise, why would you want to own them in the first place?
Take a look at Chipotle (NYSE:CMG)'s financials to see what quality growth looks like.
Remember, you don’t have to master every area of the market to be a phenomenal investor. Warren Buffett (Trades, Portfolio) readily admits that he doesn’t understand tech and he’s done okay for himself. Focus on the areas you understand and buy quality companies when Mr. Market is having a sale.
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