When to Buy a Hot Stock

If a stock trend is already obvious can you still make a profit? Yes, says former AOL finance editor Hilary Kramer. Here, she shares key strategies for riding a stock wave and jumping off on top. From her book Ahead of the Curve: Nine Simple Ways to Create Wealth by Spotting Stock Trends

We’re all familiar with the “looks too good to be true” phenomenon — and most of us are wary enough not to get burned by it. The No Money Down mortgage! The You Have Won a Free Trip to the Bahamas! postcard. Clearly, there is a catch, right? We read the fine print, and more times than not, we find we’re correct. Maybe the hitch is that there is an absurd interest rate on the mortgage, or the Bahamas trip is free — once you’ve put yourself on a mailing list and then been chosen from millions out of a huge hat. No question, there is a good reason to be suspicious of things that must have a catch.

It’s not any different in investing. Hype over a stock gets built up, and the careful investor questions if something that obvious could possibly be a good value. When the tech craze was in full force, people were singing the praises of companies like theglobe.com, an online community, or Flooz.com, which proposed an entire new, internet-only currency. If I had been a lemming and followed the herd without doing my homework, I might have jumped in and bought shares of theglobe.com after its extraordinary IPO, which opened at $9 and was over $63 on its first day of trading. It never went much higher, and in less than three years the stock was worth 14 cents. If I’d invested after that stellar first day, I would have lost quite a bit of money. Of course, I never would have had a chance to invest in Flooz, as it went belly-up before making it to an IPO. I still find myself chuckling over some of the crazy ideas from the late 1990s dot-com craze.

Or, back in early 2000, everyone was eating Krispy Kreme doughnuts and the stock was at $50. It seemed like Krispy Kreme was some big secret, and if you were in on it, that made you hip and cool. But what was the real trend here? This was a faddish brand, more than anything (coupled with a good excuse to eat a doughnut and feel hip!). Then Krispy Kreme became overexposed, sold in grocery stores and, even worse, at the highway convenience stores. Quickly the brand lost its luster, the sense that these were special food items, rare and cool as albino elephants. At the same time, the Atkins diet (another fad, as most diets are) said no to carbs, and within eighteen months Krispy Kreme had dropped to $10.

Hype can be infectious. Once you get the bug, it can cloud your judgment. But sometimes a spade is indeed a spade. In the world of trends, we like to think that the first person to identify the trend is the real winner. But I’ve found, more times than not, that when a trend is lasting and strong, getting in on the game a bit later isn’t going to hurt you. Yes, the payout might be greater for the first spotter of a trend, but a trend rider who rides the wave a bit later can still make out just fine. If you had bought Google.com during its IPO in August 2004 at $85, you would have done better than had you invested in the company four months later, at $180. But two years later, with Google’s stock soaring at $468, you would have been a winner either way. Bottom line: just because others are already talking about a stock, don’t assume that it isn’t a good investment anymore.

I like to say that if there is a sound explanation for the excitement, don’t shy away from the investment. Once again, using Google as an example, everyone was buzzing about Google when it was about to go public in 2004. It offered a service that couldn’t be beaten. How many people did you know who used Google as their home page? It was the great “discovery” that had already been discovered, and everyone wanted to turn their friends, family, and coworkers on to it. This clearly wasn’t a product that would disappear — and it was growing and getting more sophisticated by the day.

But it also clearly was already known by everyone and their mother, and people worried that it was another example of 1990s tech hype. Many people I know hesitated to invest in the IPO for that reason. They ignored what they saw with their own eyes and heard with their own ears — the obvious fact that Google was providing a superior service. To wit, this company was clearly flexible, adaptable, and eminently creative, but many investors feared another burst bubble, and as a result they didn’t jump on the IPO. If they had bought 10 shares then, for $850, as of early 2007 their investment would be worth more than $4,500.

As always, it’s important to do your research when a company seems hyped, discovered, and obvious, to make sure there is evidence of a solid trend wave to ride. But acting on valid hype is a sound trends strategy. These trends won’t generally yield blockbuster results unless you’re in on them early enough, or unless you play the Six Degrees game and jump on a tangentially related trend. But they will yield results all the same.

When investing in companies getting lots of hype, a key assessment you must make is to evaluate whether the buzz indicates a fad or a longer-term trend. If I had a dime for every fad that I’ve observed build to a frenzied crescendo, only to fizzle out within months, I’d be rich just from that. Look at kids’ products, for instance. Gummy bracelets were a fad in the ’80s, Pokemon in the ’90s. And a fad today, at the time of writing this book, is Bratz dolls. How do you tell the difference? This is tricky, but I can offer some good rules of thumb. One indicator is that fads often involve promises that are too good to be true, or some extreme change in taste or behavior. Trends, by contrast, tend to be related to more plausible fundamental changes in the way we or companies operate. Trends therefore tend to spread out into a broader range of products and services. For example, the organic trend has been powerful enough to cause biotech companies like Monsanto to change their marketing, and it’s spawned an increasing array of foods and stores that cater specifically to this demand. Both the Atkins diet and organics were premised on helping us live better, but one had staying power while the other was unrealistic for us to stick to over time. In assessing a potential trend, focus on determining if it’s likely to stick in our culture for a long or a short time. If you think it’s likely to be popular for only a short time, it’s probably a fad. A diet, a fashion, a way of thinking that isn’t grounded in anything meaningful, lasting, or sustainable — these are usually indicators of fads. I mean, how many of us really believed we could live the rest of our lives without eating pasta and bread on a regular basis?

Another good rule of thumb is the pervasiveness of an apparent trend. If the buzz about it is out of New York or Los Angeles, but no one in the Midwest has even heard about it, it may be too early in the trend for most investors or possibly just a flash in the pan. Lasting trends are widespread. Before Google’s IPO, it wasn’t just techies in Silicon Valley using the search engine for their web queries; there were plenty of people using it in Nebraska as well.

What if, in doing your research, you determine that the buzz is misguided? In other words, if you identify that the hype is over a company or a trend that simply doesn’t have lasting power? There may still be good money to be made by investing in that trend. Both fads and trends can be exploited to make a profit — you just need to be careful about evaluating and closely monitoring which you’re dealing with. The long-term trend you ride for the long haul, the fad you get in and out of quickly. During the Atkins craze, short-term investments in meat suppliers, for example, probably wouldn’t have been a terrible idea, provided the companies had solid fundamentals.

Investing in a fad is a riskier investment that takes that much more careful monitoring, because it involves your buying and holding a stock for the very short term, and jumping off before others figure out that the trend or company is overhyped. If you’re going to invest in fads, make sure you are watching the clock — and get out in time in order to make, not lose, money.

ABOUT THE AUTHOR
Hilary Kramer, a global investment specialist and author of Ahead of the Curve: Nine Simple Ways to Create Wealth by Spotting Stock Trends (Copyright © 2007 by Hilary Kramer), is the former Finance Editor of AOL and also serves as the AOL Money Coach. Her expertise in investing spans more than twenty years of experience in equity research, asset allocation, and portfolio management. She graduated from the Wharton School with an MBA, and within a decade she was recognized as one of the best equity investors on Wall Street and had amassed a personal fortune of more than $10 million. She has since then devoted her energies to helping individual investors apply the simple secrets that she used to bring her wealth and freedom from financial worries. She appears regularly as a commentator on the Nightly Business Report on PBS and has provided market commentary to The Wall Street Journal, Fox News Channel, ABC, Bloomberg, and CNBC, among others. Hilary also appears daily on the nationally syndicated radio show Doug Stephan’s Good Day. She has held directorships in both NYSE- and NASDAQ-traded companies and, from 1994 to 2002, was the senior managing director of a $5.2 billion global investment fund with both private equity and publicly traded securities.

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4 thoughts on “When to Buy a Hot Stock

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