April 27, 2021

Once it became evident late last autumn that the tens of billions of dollars spent to discover COVID vaccines were bearing fruit, the investment mindset switched from trepidation to enthusiasm. Whereas professional investors tend to be fully invested, the positive upward momentum in the equity market pulled cash and new investors off the sidelines as a fear of missing out (FOMO) condition took hold. As the economy received a booster shot from the government stimulus packages, the stock market has adapted to accommodate the strong inflows paired with an increased appetite for thematic, momentum investments. 

Given fresh cash in the market tends to have a short attention span, new investors purely allocating their capital towards momentum stocks often have a rude awakening when their favorite growth themes start to fade. Although a rising tide often lifts all boats in a bull market, we can experience periods like now which are punctuated by increased sector rotation as money flows between growth and value. Therefore, this seems like an opportune time to remind investors that slowing momentum (SLOMO) can quickly alter the performance of thematic growth investments and concept stocks.

For companies in a nascent sector, the law of small numbers often applies as it relates to delivering strong growth rates. Just as it’s difficult to fall out of a basement window, any revenue above zero can be presented as tremendous growth on a percentage basis. As long as a company can show an increasing pace of growth sequentially quarter-to-quarter, investors gain confidence that the company is taking market share or, even better, creating a new market. That growth certainty awards companies with a high valuation in the stock market as investors look to the future opportunity.

However, highly valued momentum stocks can also have high volatility partly due to investor nervousness as they recognize that growth rates can be erratic. If a company’s growth factors slow relative to the prior period, its shares can have wild swings as traders lock in gains or sell against stop losses, causing a gap downward. On an absolute basis, a given company could still be expanding, but if the sequential growth rate is declining, the stock price will typically fade. Given the difficulty in forecasting future growth rates, many analysts simply extrapolate the pace of growth from the recently reported period forward into their models. If growth slows, analysts typically lower the long-term growth rate expectations, which reduces earnings forecasts and often compresses valuation. Aside from earnings-related issues, a few idiosyncratic events which can slow momentum include executive departures, insider selling or dilutive acquisitions.

Although a “buy on dips” mentality has been prevalent, many growth investors tend to avoid adding money to companies which are experiencing slowing fundamentals until they see growth expectations stabilize. Thus, rather than try to catch a falling knife, they prefer to wait and buy stocks on the way up (staying true to their momentum roots). At the opposite end, value investors often create the bottom by absorbing shares in companies they deem fundamentally too inexpensive.

The good news is that although traders swing stocks in the near-term, in our view, company fundamentals rule the day. Stocks are leading indicators, and companies tend to rebound over time if they revitalize their trends. For companies who are improving their operations but not getting credit for the progress, activists and/or venture capital funds sometimes get involved, often taking them private to fix operations away from the public stage. There have even been companies which have roundtripped in and out of the public market during their history. Petco just went public again this year, the third time in its 55-year history, and Hertz has been public and private several times as well. Time will tell if these companies again travel through the FOMO to SLOMO cycle, but history often repeats.

In essence, when certain stocks (and themes) are priced above perfection and FOMO meets SLOMO, the underlying stocks can go down faster than they go up. At Sand Hill, we appreciate the changing investment landscape and new opportunities presented, while staying true to the importance of portfolio diversification. We strive to stay ahead of market trends, keeping you invested in accordance with your strategy so FOMO isn’t part of your daily lives.