It didn't take long for video-camera maker GoPro to teach investors a valuable lesson...
This lesson could save you thousands of dollars... or even be the source of huge winning trades for you. In fact, it's already helping my DailyWealth Traderreaders make money.
The lesson: Buying what fascinates the average investor is often a loser's game...
became available for trading on the stock market. GoPro makes durable cameras you can attach to a helmet, a car, a surfboard, or even a dog. At the time, it was one of the most exciting companies in America. GoPro was the subject of glowing stories in the media. People who normally don't buy stocks wanted to buy GoPro.
All the hype sent the stock soaring from $25 to $85... and left it trading at the incredibly expensive valuation of 10 times sales.
For many years, my friend and colleague Porter Stansberry has pointed out that a stock trading at "10 times sales" (a price-to-sales ratio of 10) is incredibly dangerous. These stocks are often ticking time bombs. It's only a matter of time before they explode. Here's why...
Most folks hear a lot about "price-to-earnings." This is a commonly used metric to evaluate stocks. But when it comes to companies with no earnings (like new, fast-growing firms), you can use the price-to-sales ratio. This values the company on its revenue, which could eventually be turned into profit.
A stock with a price-to-sales ratio of five is considered very expensive. A price-to-sales ratio of seven is absurdly expensive. A price-to-sales ratio of 10 is sky-high, crazy expensive.
A valuation this high is like a motorcycle running down a busy freeway at 180 miles per hour. Perfection is required to navigate the journey. The margin for error is so small that a tiny mistake could cause a fatal crash.
It's the same with stocks...
Expectations for a company valued at five to 10 times sales are so high that only years of perfect performance can support the stock price. But even great companies stumble from time to time. When a company that is priced for perfection stumbles, the share price plummets. Things don't have to get "bad" for this share-price drop to happen. Things only have to get "less great."
On September 30, I warned DailyWealth readers that GoPro – which was trading at 10 times sales – was one of these dangerous stocks. I told readers it would "suffer a huge correction soon."
My warning was well-timed. GoPro's business hasn't imploded... Sales are still growing. But since my warning, things have gone a little "less great" for the company. And that's all it took for shares to plummet 55%.
I believe the same situation is starting to play out with Tesla Motors Inc. (NASDAQ: TSLA, Stock Forum) the wildly popular electric-car company.
In January, we recommended selling shares of Tesla short (to profit as shares fall) in DailyWealth Trader. At the time, Tesla sported a price-to-sales ratio of nine. In the month after our recommendation, Tesla traded in a choppy, sideways pattern. But just last week, selling pressure sent Tesla to a nine-month low. This is an important development. The market is waking up to Tesla's absurd valuation and competitive threats. DailyWealth Traders are now up around 5% on the trade. You can see Tesla's downside price breakout in the chart below:
Nobody with a few years' investment experience should have been surprised by GoPro's huge decline... And they shouldn't be surprised to see Tesla on the same path. Companies that are "priced for perfection" are bound to disappoint investors.
And while you may not have years of experience under your belt, there's an easy three-question test that will prevent you from getting hurt on the next potential GoPro or Tesla...
If you're holding an extremely popular stock, ask yourself these important questions...
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Is the stock constantly enjoying favorable mentions in financial media outlets like CNBC? |
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Is the stock trading for more than the incredibly expensive valuation of five times sales, or worse, 10 times sales? |
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Is the company selling a product or service that could draw in competitors with deep pockets? |
If the answer to these questions is "yes," you're sitting on a hot, but dangerous stock. It's best to consider selling your position or
applying a trailing stop loss to it. A trailing stop loss in the 10%-15% area works well. Using a trailing stop will allow you to capture more profits if the hype-fueled rally continues. But it will also allow you to take profits when the rally fizzles.
In the cases of GoPro and Tesla, the answers to the three questions were "yes." They both traded at or above 10 times sales. They were the subjects of many adoring press mentions. And while they both build products people love, half a dozen competitors could produce them as well. This makes them vulnerable to cutthroat competition... and dangerous stocks to hold.