My view on what's going on in the financial markets and the global economy, and a few other things that might interest me from time to time.

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  • tim@emorningcoffee.com

My (Bad) Experience with Momentum Stocks

I have owned a few so called “momentum stocks” which, in retrospect, I exited too quickly. It is with some regret that I want to focus on my own experience in this article on the momentum stocks that I was somehow smart enough to buy relatively early, but with which I then parted ways too soon, at least based on current prices. These include both Tesla (TSLA) and Zoom Video Communications (ZM), and to a lesser extent (and although more mature), Netflix (NFLX). I will talk about these stocks in a moment, and also about the role that short sellers likely played in their share price appreciation. Let me first start by first providing some context in terms of the way I view investor types. Here’s the way I see the lay of the land in this respect.


1. Long-term investors – I consider long-term investors to simply be those that invest in and retain positions in stocks or indices based on long-term conviction and views, weathering the cyclical ups and downs and rarely trading. Investors that play indices are acknowledging that over the long-term, equities outperform other asset classes, accepting that the trade-off is higher volatility over time vis-à-vis other asset classes. Similarly, buyers of stocks which they believe “represent the future” or are wrapped around an emerging mega-trend are willing to weather gyrations in quarterly earnings and revenues because they believe that the company will flourish in the long-term based on select macro trends, including things like changing consumer preferences, demographics, etc.


2. Investors focused on fundamentals – Fundamental-driven investors do a lot of work on companies, analysing their revenue drivers, cash flow generation, quality and depth of management, business strategy, etc., to identify i) sound companies so that they can buy their stock when the shares seem undervalued in the market, or ii) weak companies so that they can sell (short) their stock when their shares seem overvalued in the market. These investors can unwind either side of these trades when they believe a stock becomes fairly valued and move on to other overvalued / undervalued situations. They rely on many valuation metrics with which you are certainly familiar, like price-to-earnings ratios, market value-to-book value ratios, and so on.


3. Investors focused on technicals – Technical analysts are also known as chartists, and they tend to calculate, monitor and make decisions on a stock’s price based solely on its price action (versus history) and price patterns. For example, if a stock rises above its 200-day moving average, it has “broken out” and is destined for more gains.


4. Momentum investors – These are investors which buy stocks that are hot (meaning they are going up day after day) and sell what’s not (meaning going down day after day), independent of the business fundamentals of the company and valuation metrics of the particular stock. They trade frequently in an attempt to identify shifts in momentum either way and position their portfolios accordingly.


Most experienced investors and analysts would probably consider themselves to be one of the first two types of investors, even though – with respect to the second category – the efficient market theory would say that there are no undervalued or overvalued stocks because everything is fairly valued. The first type of investor feels to be the most uncommon at the moment, mainly because he goes about his business and rarely trades. However, this rather quiet and conservative investment strategy can sometimes overlap with momentum strategies, at least in the early stages of a stock “emerging”. A good example of this at the moment involves stocks that have benefited from unexpected changes in consumer and business preferences caused by the CV19 pandemic, which will likely have a profound effect on demand for certain products and services in the future. The initial emergence of such a company can be traced to the recognition and acknowledgement of a mega-trend that appeals to buy-and-hold investors, but as the company’s stock appreciates to the point where its value becomes completely divorced of fundamentals, momentum investors often take over, pushing the stock higher and higher.


Even though the first two categories of investors might be what many of us consider to be the “smart money” guys, momentum investors have become increasingly prominent, and the reality – like it or not – is that investing in momentum stocks seems to be working well. Inevitably, this has been helped by things like fractional share investing and nil commission trading, both of which have opened up the potential investor base dramatically. Arguably, momentum strategies may overlap slightly with technical strategies because – by its rudimentary definition – momentum occurs when a stock moves one direction or the other quickly. However, I believe pretty strongly that any sort of technical analysis is mainly a sideshow for momentum investors, as foreign to their thought process as fundamental analysis.


Now let me turn to my own mistakes that, in retrospect, were caused by the fact that I was too dogmatic and narrow in my approach. These errors have involved the three stocks I mentioned earlier - Tesla, Zoom and Netflix. I am picking on these three companies because they have had sharp ascents during this market recovery that need some explanation, and in every case, I bailed out too early because I thought they were over-valued (and still do). I have written about both Tesla and Netflix in the past in my blog, and you can find the articles here: Netflix (Feb 14th and April 17th), and Tesla (Jan 7th, Jan 10th, and Feb 13th) .

The analysis of the three companies below is not a “deep dive” per se, but rather a cursory look at each company. From there, I want to talk about the role of investors that short stocks as part of their fundamental analysis (investor category 2 above) in the unusual appreciation of prices independent of fundamentals.


Netflix


Let me start by saying that Netflix is an impressive company, and I completely buy into the positive attributes of the company. Netflix will continue to benefit from its first mover advantage, enjoying a substantial head start as far as the number and scope of subscribers in its streaming business. Netflix is a recognised global brand and is entrenched with its customer base. It has consistently delivered extremely high quality content for its subscribers. It is a well-managed company and has shown in the past that it has the foresight to recognise trends ahead of the trends becoming mainstream, and then emerging as a viable disrupter. I can go on and on about the positive business attributes of the company, similar to Tesla, but let’s look quickly at the credit metrics and valuation.


Netflix is a high yield company, rated Ba3/BB-. The company remains dependent on the capital markets for financing for the development and production of its original content, on which it is more and more dependent because new streaming competitors – many of which are legacy production companies – are taking back their content from Netflix. In addition, the company’s higher margin and more loyal subscriber base is reaching penetration in developed markets like the U.S. and Europe, whilst its growth is skewed increasingly towards less loyal and lower-margin customers located in emerging markets. There is still a lot of growth ahead for Netflix, but the company will remain cash flow negative for some time in spite of being bottom-line profitable. As a result, it will remain dependent on ongoing investment to continue its new content development, which preserves its existing customer base and allows it to gain new subscribers. It feels like being on a treadmill to me, in that investors might one day ask, “how and when can I get off?”


Here’s how the company’s shares have performed YtD, a period in which the combination of the lock-down and momentum has carried to stock to new highs.

Although Netflix has had impressive growth in subscribers and revenues over the last five years (32.5%/annum and 57%/annum, respectively) and now has over 193 million subscribers, I struggle to justify a P/E multiple of 82.2x when the competitive landscape is changing so rapidly as more and more formidable competitors enter the streaming market, including legacy production companies like Disney, HBO Max (AT&T), Universal Studios (Comcast) and ViacomCBS (not to mention incumbent Amazon Prime and another new entrant, Apple+). Netflix’s counter-argument to new entrants has been that “a rising tide lifts all ships”, meaning all of the streaming companies can succeed without stealing market share from each other, but rather stealing market share collectively from incumbent (non-streaming) players including traditional terrestrial, cable and satellite TV companies. As with the other two companies I mention below, my concerns are not with Netflix as a company, but rather with the valuation of its stock. The stock has been on a tear, appreciating 152% YtD and sliding through the darkest days of the CV19-led March sell-off with scarcely a blip in its price.


It’s recent 2Q2020 earnings announcement (see here), in which some concerns about the ongoing robustness of subscriber and margin growth were conveyed by Netflix management, poured some call water on the stocks ascent, at least for the moment.


Tesla


As far as Tesla, I don’t even look at the company’s fundamentals anymore because the company produces such a small number of cars and has yet to turn a full year profit yet has a market cap of $290 bln. In 2018, there were 92 million automobiles produced, led by Volkswagen (10.9 million vehicles / $85.8 bln market cap), Toyota (10.6 million vehicles / $174.2 billion market cap) and General Motors (8.4 million vehicles / $37.4 bln market cap). Tesla had LFQ run-rate of just shy of 400k vehicles, and says it will produce 500k in 2020 (which we will hear more about when TSLA announces its earnings after the market closes today). This means that Tesla has a market capitalisation that is just shy of the combined value of the three largest automobile manufacturers in the world, and these three collectively produce 60-75 times as many vehicles. In the narrower category of electric cars, Tesla is indeed the market share leader (16.6% in 2019 according to Statista). However, although trailing Tesla by units of electric cars sold, all the major global manufacturers of automobiles are now producing and selling electric cars, with some of the most active being lesser known (in the west) Chinese manufacturers, some of which were directly set up to challenge Tesla in China. Sure, the market share lead and superb quality of Tesla’s shares is worth something, but does this valuation make any sense at all to any rational investor?


Here’s how the stock has performed during the last year, when it has increased nearly six fold from $255/share to over $1,500/share.

In the early stages of its life as a company, I would have argued that Tesla was a solid and interesting company with a fairly unique idea, recognising a “macro trend” early as growing environmental awareness began to favour automobiles powered by cleaner and more efficient alternatives like electricity at the expense of the production of automobiles powered by petrol. However, I believe that the valuation of Tesla is so divorced from fundamentals that I struggle to rationalise it on any grounds, even though I love the mission of Tesla and the quality of their cars. Clearly, the momentum investor base for the company has broadened considerably, and these investors are carrying this stock to ridiculously high levels. I am reminded also that Tesla – like Netflix – is a non-investment grade credit company (much weaker than Netflix with B3/B- ratings) that is significantly cash flow negative, meaning it remains dependent on financing in the capital markets to push itself forward. I have little doubt that the day of reckoning will come when the value of the company must become supported by its fundamentals, not just momentum.


Zoom Video Communications


Let me discuss last one stock that has absolutely sizzled during the CV19 lock-down, and that’s Zoom Video Communications (ZM). Not many people had heard of Zoom before the pandemic hit, but now, everyone knows Zoom because it has clearly benefited from the “stay at home” requirements in most parts of the world. The company is bottom-line profitable, more than Tesla can say, but its revenues are yet to cross $1 bln on a rolling 4-quarters basis (although it is close now). The company has a market cap of equity of $73.3 bln, which is around 73x trailing revenues and around 1,500x trailing earnings. To be fair, I know little else about Zoom, except that it makes a great product that I discovered during the CV19 lock-down. As I used Zoom more and more frequently, I appreciated the high-quality video conferencing capabilities that the company offers (although I never really understood exactly how they make money, especially off of users like me). Zoom is undoubtedly benefiting from a long-term mega trend resulting from the pandemic in that the world is likely to undertake significantly less business travel and face-to-face meetings in the future, to be replaced by

more interaction via video conference. Yes, there is competition, and yes, Zoom has faced criticism over its security, but the reality is that it makes a very good product. As with the others, time will be the judge as to whether or not this stock has gotten too far ahead of itself. I certainly bailed out too early, because the stock has really run. The table above shows Zoom's share price trajectory. The shares have increased nearly four times in the last year.


The Role of Short Sellers in These Companies


I believe that the role of short sellers in both Tesla and Zoom has been significant, but most prominent in the case of Tesla. Let’s step back a moment first. Selling a stock short works in two instances. The first is when a business is fundamentally overvalued and enough investors agree with this assessment so that they start to unwind their long positions, pushing the shares down and overwhelming momentum buyers which can fade quickly. The second is the more troublesome matter of irregular accounting or other fraudulent activity that comes to light, causing investors to run for the exits in droves. Both Luckin Coffee and Wirecard are recent examples of these. This revelation usually causes the shares of such companies to completely collapse, rewarding those shorts that did their work sufficiently to identify potential irregular activities.


In the first role of short investors (i.e. the one not involving fraud), being short doesn’t necessarily always work. Even when investors sell a stock short because it is overvalued on a fundamental basis, if enough investors don’t agree, the reality is that the large short position can actually push a company’s shares higher. How? It’s simple. If the overvaluation is ignored broadly and strongly by enough momentum investors, the stock will push higher perhaps even as short interest increases, eventually overwhelming short sellers. Then, as the share price continues to increase inflicting more and more pain on investors that have sold short, these investors often have no choice but to cut their losses by unwinding their positions (by buying the stock to cover their short), providing even more fuel to the upward price trajectory.


I recall seeing Tesla shares with a short interest of around 20% (of outstanding float / daily volumes) towards the end of last year, as fundamental investors felt at $300-$400/share, Tesla was overvalued and destined to fall. However, Tesla has proven to be a momentum investor’s dream stock as it headed north faster and faster, often gapping up by 5% or more in a day. Undoubtedly, short covering has contributed since short investors have incurred significant losses as the stock rapidly appreciated, forcing them to cut their losses and cover their positions, fueling the next leg up. Currently, the short interest in Tesla is down over 50% compared to a few months ago, to 9.47% (short interest % float), still very high compared to most stocks on an absolute basis but decreasing quickly as shorts have been burned, fueling the price rise. In some respects, the fact that the price of Tesla’s stock has dominated news about the company has taken the shine off the excellent electric cars its makes, many of its market-leading innovations, and its overall disruptive approach to attacking the traditional global automotive industry. Having said all of this, there is no way that a car maker which produces only 400-500 thousand cars should be worth nearly as much as the three largest global car manufacturers (VW, Toyota and GM) combined, which collectively produce around 30 million cars per year. Electric cars are the future, but this will entail a gradual shift over a long period of time.


As far as Netflix, there is also a role for short sellers in this stock, as it remains the most shorted stock of the FAANG+M bunch, at 2.56% (short interest % float), as you can see from the table below.  There is little doubt that Netflix has benefited from momentum investors 

driving up the price, and although perhaps somewhat divorced from fundamentals, its valuation is not nearly as ridiculous as Tesla.


Zoom might be closer to Tesla than Netflix, at least in terms of its short interest as you can see in the table above. As with Tesla, short covering on Zoom could be a contributing factor to the stock’s one way ascendancy although I do not have historical data on the short interest levels for Zoom. This makes me believe that when a stock has an unusually large short interest, it can cause it to move one way or the other quickly, depending on whether short investors or momentum investors have the upper hand. In the process, solid fundamental analysis more or less gets cast aside.


Conclusion


I decided after holding Netflix, Tesla and Zoom to sell them, and I did this way too early. The reason is that I felt all three were overvalued based on their fundamentals because the stock price had gotten too far in front of the level that could feasibly be supported by fundamental analysis. In case you are wondering, I have heard the Amazon story before, and I hold this stock too (although I have lightened into the post-$2,000/share rally). My mistake in the case of Tesla, Netflix and Zoom was to ignore the important role of momentum investors, who care little about fundamental valuation, as well as the failure to acknowledge the role of the large short interest. I still expect the tide will turn one day on all three of these very interesting companies, not per se on the company itself in each case, but on the stock price. If this were to happen, I doubt these companies would really consider this to be a bad thing, as I imagine all would prefer more focus on their business and many successful innovations rather than just the price of their shares. And I would absolutely look at buying all three stocks again once reality sets in, as I am admittedly “old school” and stuck in the rut of looking at fundamentals.

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