From the Manson family to the Branch Davidians, there have been some truly horrific cults in American history that have ruined the lives of both followers and outsiders. So when market analysts refer to certain stocks in the market as “cult stocks,” investors should take notice.
Cults are often led by charismatic leaders who offer followers hope of a better future, give them a sense of purpose and make them feel like they are part of something bigger than themselves.
Of course, when analysts refer to stocks as cult stocks, they don’t mean it in a literal sense. However, investors in certain companies can display a dangerous cult-like mentality.
Typically, stocks are valued based on dozens of metrics that incorporate earnings, growth, cash flow, revenue, margins, debt and other measures of business performance. These measures serve as a guide for investors to use to determine how much they should pay for a stock. However, at the end of the day, buyers are free to pay as much as they want regardless of the valuation metrics.
Exception to the rules. Cult followers can be convinced that the words of their leaders override the norms. When it comes to the stock market, words from a company’s management during presentations, interviews and conference calls are very convincing to a trusting investor. Skilled CEOs are savvy at spinning the truth and explaining away criticism.
The story often goes something like this: It doesn’t matter that our company isn’t profitable and is millions of dollars in debt because we are changing the world with our new product and you will want to be a part of it.
Cult stock investors often suffer from confirmation bias as well, which is the tendency to seek out information that supports previously-held opinions and ignore conflicting evidence. Cult stock investors may be much more willing to believe a CEO’s hype than an outside criticism.
A familiar product. Investors can even be so impressed by a company’s product or service that they will dive into a stock without paying any heed to how overpriced it may be.
“I think part of the reason that investors are drawn to stocks with high valuations is that often these are companies that have products that they are familiar with that have a new twist to them,” says JJ Kinahan, chief market strategist at TD Ameritrade.
Investors may use the product and love it, but that doesn’t necessarily mean the company’s stock is a good investment. There are plenty of people who love ice cream, but few people would pay $100 for a pint of Ben & Jerry’s.
Blind faith. Nicholas Colas, chief market strategist at Convergex Group, says an exciting product is one of three traits that cult stocks tend to exhibit. They often have visionary leaders and impressive sales growth as well.
“As a result, valuations tend to get pushed to the background,” Colas says. “Investors see a great product, a rock star CEO and a track record of growth. They just want to be along for the ride.”
This blind faith may seem like a bad investment strategy, but it’s relatively common when it comes to cult stocks.
“My impression is that investors of cult stocks fall into one of two camps: those who aren’t interested in a stock’s valuation and those who believe the growth potential for the earnings justifies the astronomical valuations,” says Owen Murray, the director of investments at Horizon Advisors.
The second class of investors Murray describes are simply so excited about the potential they see in a stock that they will buy it at any price.
Former Federal Reserve chairman Alan Greenspan famously called this mentality “irrational exuberance.” It’s the same mentality investors tend to demonstrate during market bubbles.
Popular cult stocks. While investors may think of cult stocks as shady companies selling weight-loss pills or snake oil, they are actually some of the most popular public companies in the world. Stocks with extremely high price-earnings ratios, such as Netflix (ticker: NFLX) and Amazon.com (AMZN), are often considered cult stocks.
Greenspan’s comment came during the dot-com bubble of the 1990s when internet companies’ share prices were soaring based on their page views rather than sound financial performance. Today, the market reacts much more strongly to Amazon and Netflix’s subscriber counts rather than the companies’ reported income.
Tesla Motors (TSLA) also fits the bill of a cult stock. The stock often trades up or down in response to tweets and presentations by charismatic visionary leader Elon Musk, but Tesla has yet to actually turn a profit. Investors simply trust that Musk will deliver.
“A lot has to go right in order to make money,” Murray says of cult stocks. “It is much safer to invest in companies that are more mature and have a proven history from which you can properly judge value.”
Horizon Advisors takes risk mitigation one step further and recommends investors always opt for diversified exchange-traded funds and mutual funds over individual stocks.
Of course, despite all the negative connotations associated with the word “cult,” cult stocks aren’t necessarily always bad investments.
The key concern when it comes to cult stocks is the risk associated with investing in extremely expensive, volatile and unpredictable stocks. For every Alphabet (GOOG, GOOGL) that ends up actually changing the world, there are…
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