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Analysis & Learning

High momentum growth stocks. Is it game over?

April 1, 2021

It is a testing time for growth share investors. They have had a great run since March 2020. Investors are sitting on big profits. US Treasury bond yields have trebled from the August 2020 low point of around 0.5pc. Margin debt has risen since last March from $500bn to a record $800bn. It is not too surprising that we have seen profit taking and once the selling starts it tends to feed on itself for a while as falling share prices trigger margin calls.

Technically, falling share prices manifest in broken uptrends and falling moving averages and there are quite a few of those around. My rule is that once a share starts falling it is best to not buy until there are clear signs – a broken downtrend and a turn for the better by the relevant moving averages – that the shares are starting to climb again. Once shares start to fall there is no telling how far they may tumble.

Last Spring shares in one of my favourite businesses, Carvana, a company led by a team of all-star graduates, which is disrupting the US used car industry, plummeted in just two months from a peak $116 to $21. Investors were worried that because of Covid-19 the company would be left with a large stock of valueless automobiles as the global economy tanked and consumers stopped making large purchases. The fears were vastly overdone and in the next six months the shares rose more than 10-fold to eventually treble the former peak.

I know it is hard not to panic when a share you hold seems to be in free fall but the founding managers of the business typically don’t and it usually works for them so most investors should do the same. The problem is that we only know what a share is going to do with hindsight. The really smart thing to do with Carvana would be to sell at the top, buy back a much bigger holding at the bottom and order the champagne. Unfortunately, I don’t know how to do that and I have never met anyone who does.

Curiously, I am reading a book called Notes on Deep Time about geology, which sheds some light on the difficulties facing share investors. Back in the 1960s many scientists were convinced that they would soon know how to predict earthquakes. Now there is not a scientist in the world, who believes there is any possibility of that happening in the foreseeable future. The moment when accumulated stresses in rocks and fault lines deep below the earth’s surface reach the point where an earthquake is triggered is a total mystery and likely to remain that way.

Ditto with the ups and downs in share prices. This is why so many wise investors, led by the great Warren Buffett, long ago concluded that there was no point in trying. As Buffett once said, investing in the stock market is like going into partnership with a manic depressive. Instead, sensible investors have devised strategies built around being in a share for the very long term. Over long periods share prices are determined by corporate fundamentals. In the short term, over days, weeks, even months, much of the movement relates to investor psychology and nobody has yet come up with a way to do more than guess at how that is going to behave.

With many shares Buffett even gives himself the advice I give my subscribers. He says he will never sell.

Once you decide to be a long-term investor many things fall into place. First, it is clear that what you buy is far more important than when you buy. Warren Buffett has another great quote for this. He says it is better to buy shares in a great business at a reasonable price than to buy shares in a reasonable business at a great price. All your focus should be on the quality of the business – growth potential, management, industry dynamics and the like. Get that right and you will do well; maybe extremely well.

It may sound as though that means spending long days and nights with wet towels wrapped around your head studying reams of statistics but it is nothing like that. Great businesses are usually obvious. If you have to keep asking yourself if it is great it almost certainly isn’t. This is also precisely the job we try to do for you at Quentinvest. All my effort goes into finding great stocks and most of the ones I find are great; that doesn’t mean their shares will rise all the time but they will most of the time and over long enough periods, the investor version of the geologist’s deep time, they will be profitable.

Long term investors can also try to turn volatility to their advantage. One way to do this is by a strategy known as pound cost averaging. You could invest a certain amount every month in a fund like SPY, which tracks the S&P 500 index or QQQ, which tracks the Nasdaq 100 index. By doing this you will buy more shares when prices are low giving a strong bias to a low average cost. This makes eventual profits almost certain, especially if, as is also likely, the index makes upwards progress over time.

A variant on this strategy is to buy not every month but every time your chosen indicator gives a buy signal. For example, you could decide to buy every time selected weekly moving averages give a golden cross buy signal. A golden cross happens when the shorter moving average rises up through a longer period moving average. This will ensure that all your purchases are made into rising prices after a fall which is often a good time to buy.

I have recently been considering another approach which I call ‘Buying the Green’. The charts I regularly look at are candle stick charts. I choose the period for each candle, which can be daily, weekly, monthly or any other period you choose. The colour of the candle is determined by whether the price ends the period up – green, or down – red. In this strategy you buy at the end of every period if the candle is green. If it is red you wait. You could either buy on every single green, a very aggressive approach or less aggressively you could buy only on the first green after a red.

In the old days the dealing costs of such a strategy would have made it impractical but things have changed. There are trading platforms now that offer commission free trading and also allow you to buy fractions of a share with high priced shares like Tesla and Amazon. This means you could economically buy very small parcels, say $50 a time on every green or invest more if that seems too small. Over time you should still build a decent holding and you would be certain to make a profit eventually unless the business went bust.

Well-chosen shares go up over time, which would make this strategy very rewarding. Alternatively, you could focus on ETFs. ETFs are regularly rebalanced around the most valuable companies in an index and because they are portfolios of shares they never go bust.

I use IG for my investing. In a share account, so with no scary leverage, if you trade more than three times a month, which is highly likely with my buy the green strategy, you pay zero commission on US shares and £3 each time on UK shares. IG doesn’t offer fractional investing so this would be an expensive strategy with Amazon on a share price around $3,000 but most shares have far lower values.

My subscribers will know this but I just want to make totally clear that a high price does not mean a share is expensive in terms of company valuation. High prices usually come about because a share, like Amazon, has been rising for a very long time without any share splits. The key to how a company is valued is its market capitalisation divided by earnings and the market cap is itself determined by the number of shares in issue multiplied by the share price.

If you held Amazon and they had a 100:1 share split you would own 100 time as many shares but the price would drop to around $30. Would this mean the shares had suddenly become screamingly cheap and should be bought immediately for a quick return to $3,000? Not at all; the truth is nothing would have changed but the nominal price of the shares. The valuation of the business would be identical (100 x $30 or 1 x $3,000) multiplied by the number of shares in issue.


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