Momentum investing became very popular during the technology run of the 1990s, which ended with the dot-com bust. Momentum investors look for stocks in early stages of strong top-line and bottom growth that could continue based on fundamental business-model or event-specific catalysts. The continuation of this historical performance should add “momentum” to the stock valuation and price performance (i.g., Intel). The downside of this investment style occurs when a company breaks its positive trend of performance or even underachieves market estimates. The decline can be quick and very painful as “momentum” investors frantically exit the stock (e.g., Cisco).
We thought it would be timely and educational to review the rise and fall of the collaboration-and-communication stocks as a case study in momentum investing. In a poor market, it is important to review the historical performance and reasoning behind the rise or fall in an effort to find solid investment opportunities. In the case of the collaboration-and-communication sector, the market punished the group too severely based on unachievable expectations.
- Step 1: Event-Driven Ignition: Following Sept. 11, Wall Street reviewed many industry sectors, assessing who would suffer or benefit. Portfolio managers identified collaboration and Web communication as a primary benefactor due to a reduction in travel, which prompted aggressive buying.
- Step 2: Momentum Builder: Third-quarter reports reflected improved operating metrics, showing little boost from Sept. 11. This implied the potential of a tremendous upside to future earnings reports, as Sept. 11 interest would be monetized, heightening the interest in the segment.
- Step 3: The Rollover: Strong interest by institutional and now individual investors had most stocks up more than 100 percent from Sept. 17 to Nov. 15, which was too far too fast. At this point, stocks were trading on earnings revenue expectations that were not attainable in a reasonable time frame, creating the perfect “rollover.” A rollover occurs when demand begins to stall (peak) and “roll over” as investors take profits, eliminating the support to sustain current trading levels.
- Step 4: Negative Information: “Short sellers” made money on the way down by selling the stock at high prices, buying it back at lower levels and capturing the spread for profits. With demand waning, the short seller began an information campaign, touting competitive threats (Microsoft), pricing pressure (Genesys) and customer dissatisfaction (WebEx). These stories changed investor sentiment, sending the stocks downward.
- Step 5: Confusion and Expectations: In this particular case, confusion regarding pricing, competition and fourth-quarter earnings expectations was aided by accounting concerns generated by the fall of Enron. These dynamics created the combustion that caused the group to decline 27 percent during February 2002. Momentum investors exited the stock as their thesis began to crack.
- Step 6: The Aftermath: Fundamental investors are left dazed and confused to assess the future of the group. A negative cloud looms, waiting for the next catalyst to brighten the group’s outlook, which could take at least several quarters. It is in these periods that smart investors do their diligence to determine the truth. Unjustified declines create the best investment opportunities.
Not only did the group make a round-trip in terms of stock performance from Sept. 11, 2001 to Feb. 11, 2002, but the stocks fell an additional 40 percent or more as negative sentiment overwhelmed the market. This was a very dramatic case of momentum investing, but an excellent case of the power of market psychology and investor sentiment. It is important to know that each investment style or discipline will outperform in different market environments. It is difficult as an investor to time market inflection points. That is why diversification and a long-term horizon have always been the investor’s friends.
Peter L. Martin, CFA, is a managing director in the Equity Research department of Jefferies & Company Inc., providing in-depth coverage of the knowledge services industry.