Why Cult Stocks Should Scare You

Daily investment jargon includes all kinds of established categories for stock types, such as large cap, small cap, growth or value. In other instances, stocks are grouped by sectors or segments such as financials or technology.  People invest in these stock groups every day.

However, there is another unofficial name for a group that reflects a stock or concept du jour --   a name or concept in favor for a short period of time. I refer to these as “cult stocks,” and as the name suggests, these stocks attract the novice investor seeking bigger and better returns. They also tend to have a maniacal following. On the surface, investing in them appears attractive. But, like a wolf in sheep’s clothing, they are scary and should be avoided.

One example of a cult stock is Twitter (NASDAQ – TWTR.) For the record, I like Twitter. I use it (for business purposes only) but I see value in its offering.  The stock has its fans and detractors and users of the service who are also investors tend to be fans of the stock too, and that is dangerous. Why? I believe its true value as a stock is far less than its current market cap and that could end up being a big problem. 

Yesterday, Twitter stock rallied due to its better-than-expected business performance. I say business because the number of users online exceeded expectations, as did some revenue metrics. Still, despite this accomplishment, Twitter reported a loss of over $144 million on a GAAP basis. Even if one were to look at the $0.02 per share GAAP results, it seems outrageous that the stock would be worth $27 billion, or 27x this year’s estimate sales. But, since it is a cult stock, it is afforded this valuation. Rest assured it is not sustainable.

Cult stocks do not have to have high market caps or valuations. It is not uncommon for stocks of companies with the latest consumer trends or the appearance of being a player in the new trend to build a large and loyal following of investors. Like a cult, these companies are led by evangelists, rather than operators. And, like cult leaders, they can whip up a crowd into a frenzy, and through the issuance of flowery press releases and meetings, keep their stocks well above fair value.

While it is clear that these types of stocks should be avoided as they represent more hype that substance, it is impossible to predict when the other shoe will drop and too hard to forecast the order of magnitude of the inevitable fall.  Therefore, do not play against the trend as you could be burned just as badly as those in support of it. The most important thing is to be aware of them so you can stay on the sidelines and gravitate to other, non-cult stocks.  

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