Many people are emotionally invested in Twitter and don’t comprehend the reason behind its poor track record as a publicly traded stock.
Twitter is still a great product. Many of us still love it and use it every day. The problem with Twitter is that they stopped growing fast enough and when you stop growing, the market starts to pay attention to valuation. Its valuation is still steep.
When a young tech company is still growing quickly, the stock market doesn’t pay attention to valuation because it assumes that profits will come later. It is the Amazon’s model. Reinvest everything you make in projects that will fuel future growth and presumably a lot bigger profits down the road. Essentially, investors are often taking a leap of faith in:
1) their own ability to manage risk properly and
2) the ability of management to deliver.
Financial markets are forward-looking by default. They often discount events that haven’t happened yet. As a result, they will sometimes price in events that will never happen. Take the story of Yelp for example. YELP quadrupled long before it reported its first profitable quarter. Take a look what happened after this long-awaited event. The market gradualy realized that its expectations for Yelp are way too high and that its management won’t be able to deliver.
Yelp is hardly the only example of a public company rising quickly in market cap while still losing money every quarter. Companies could be losing money because they invest heavily for future growth or they could be losing money because of a flawed business model. You want to stick with the former. The problem is that in many cases, the reason is clear only in hindsight, which means that we have only one option when dealing with momentum stocks – trust price. If price action gets us in, price action should gets us out.
It is normal for a story stock to double and triple in a year as investors’ expectations grow much faster than the ability of a company to deliver. In fact, this is the story of most momentum stocks and the reason why many of them give back 50% to 80% of their upside move.
The lesson? Always have an exit strategy, because sooner or later every trend ends.
