For many investors, the ultimate dream is to find that one ticker symbol that everyone is talking about—the one that dominates the headlines and promises to revolutionize the world. However, history often proves that the hottest stock in the hottest industry having the most publicity is most likely the worst stock to invest your money in.
Market euphoria frequently blinds investors to structural weaknesses. When a stock becomes a “story stock,” its price decouples from its underlying value, creating a dangerous environment for your capital.
1. The Perils of Popularity and Competition
Too much competition due to popularity.
A surge in industry popularity is often the beginning of the end for high margins. Too much competition due to popularity creates a race to the bottom. It is because as the business attracts crowds, the competition on prices start, the prices will go down, and as a result nobody will earn any profit.
Real Business Example: The early days of the British bicycle boom in the 1890s or the recent cannabis sector in North America. In both cases, hundreds of firms entered the market simultaneously. In the cannabis industry, companies like Canopy Growth and Aurora Cannabis saw massive valuations collapse as oversupply led to a pricing war that wiped out profitability across the sector.
2. The Expectation Gap
Mismatch between expectations and real earnings.
Stock prices are a reflection of future expectations. When those expectations are set at an impossible level, disaster follows. A mismatch between expectations and real earnings is a primary cause of portfolio destruction. High expectations drove the price up to record high, but the company failed to deliver earnings, and the stock crashed.
Real Business Example: Peloton during the pandemic era. Investors priced the stock as if the global lockdown would last forever. When the world reopened and growth normalized, the company couldn’t meet the astronomical earnings targets baked into its valuation, leading to a massive share price retreat.
3. The Fallacy of the “Next Big Something”
The next big something almost never is.
Wall Street loves a sequel, but the next big something almost never is. When a new company is marketed as the “next Google” or the “next Tesla,” it usually signals a lack of original competitive advantage. It usually suggests the end of prosperity not only for the imitator but also for the original to which it is being compared.
Real Business Example: Nikola Corporation was frequently branded the “Tesla of trucking.” The hype surrounding its hydrogen-electric semi-trucks led to a valuation that briefly eclipsed Ford, despite the company having zero revenue. The subsequent fallout showed that being the “next” version of a pioneer rarely results in pioneering success.
4. The Danger of Diworsification
Diversifying unreasonably.
Growth for the sake of growth is a red flag, specifically when it involves diversifying unreasonably. This occurs when management begins acquiring smaller companies for much higher price, and beyond the core business or understanding. And then selling that unrelated business for less than the original purchase price.
Real Business Example: AT&T spent tens of billions to acquire DirecTV and Time Warner in an attempt to become a media mogul. Realizing they lacked the expertise to run a Hollywood studio and a satellite provider in the age of streaming, they eventually spun off these assets at a significant loss to their original investment value.
5. Whispers and Imaginative Solutions
Listening to whispers.
Beware of listening to whispers. These are often companies that could be big winners but never will because their solutions are very imaginative or impressively complicated. Their stories have emotional appeal built on hope but no substance – not realistic business models, hence no earnings.
Real Business Example: Theranos is the ultimate cautionary tale of an “imaginative” solution. The promise of revolutionary blood testing was highly emotional and complex, but the underlying technology simply did not work. Investors lost billions chasing a whisper that lacked a functional business model.
6. The IPO Trap vs. The Spin-Off
IPOs of brand new enterprises.
Investors are often lured by the “newness” of IPOs of brand new enterprises. However, they are very risky because there is so little information and past record. In contrast, IPOs of companies that have been spun out of other established companies tend to be better investments because they come with historical data and existing infrastructure.
Real Business Example: Contrast the volatility of Deliveroo’s debut, which saw shares tumble 30% on its first day, with the successful spin-off of PayPal from eBay. PayPal was already an established, profitable entity with years of trackable performance before it began trading independently.
7. The Vulnerable Supplier
The Middleman.
A “middleman” business model can be lucrative until it isn’t. The Supplier is often a middleman that is too dependent on a few clients only. A company that sells 25% to 50% of its inventory to a single customer might be a disaster when losing that customer.
Real Business Example: GT Advanced Technologies signed a massive deal to supply sapphire glass for Apple. When Apple decided not to use the material for the iPhone 6, the supplier, which had geared its entire operation toward one client, was forced into bankruptcy almost immediately.
8. The Allure of the Flashy Name
Stocks with exciting names.
Marketing experts know that a name can manipulate perception. Stocks with exciting names are often used to mask a boring or failing business. A flashy name (e.g. ‘leading’, ‘advanced’, ‘micro’, mysterious acronyms, starting with x or y or z, etc.) in a mediocre company can attract investors giving them a false sense of security, or a big institutional following.
Real Business Example: During the dot-com bubble, a company called ZapMe! Corp (an educational technology firm) saw its stock soar purely on the “cool” factor of its name and its affiliation with the internet trend. More recently, during the 2017 crypto craze, Long Island Iced Tea Corp changed its name to Long Blockchain Corp. The stock price spiked 200% in a single day despite no change in its actual beverage-making business.
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