Today's Lesson: Paying the Price for Not Respecting Valuation

Wednesday, October 06, 2010

None of us would be involved in the financial markets if it weren't challenging, right? I am down significantly today giving back all my gains from yesterday's large advance. Two stocks I bought yesterday saw negative news overnight with Gleacher & Co cutting F5 Networks, Inc. (FFIV) to Neutral from Buy and Intel announcing its development of a tool that will allow applications to run on Intel processors as opposed to the Arm Holdings (ARMH) based processors most run on today. I also bought (CRM) which suffered today from the blanket selling seen across the much-hyped cloud computing space.

Most momentum styles are vulnerable to rapid and wild swings in sentiment and today's severe move lower in these names cost me a lot of money. But was this just bad luck? I would say no. I think this is clearly a mistake of mine for paying up for these companies. As I work on my skills in momentum swing trading, I understand how useful it is to study the fundamentals of the underlying companies. Only then do I use my feel coupled with some pattern recognition to time entries and exits.

Quite simply, I ignored the fundamentals yesterday when I bought ARMH, FFIV and CRM. FFIV is trading 37 times forward as an internet service provider, ARMH is trading 44 times forward in the competitive semiconductor space and CRM is trading 74 times forward in the cloud space. On the other hand, there's a companies like Apple (AAPL) still selling at a cheap 16 times forward even after a 50-point advance and Google (GOOG) trading 17 times forward even after momentum kicked in and the stock jumped 17% in September.

Momentum trading and value investing are probably about as opposite as could be. But, there are some very useful ideas from the value style that can be applied in concept. My thought process in seeing yesterday's trades as fixable errors is applying the concept of "margin of safety". While most movements in the market are completely uncontrollable, the long-term value investor is taught to find valuations that offer a compelling margin of safety so that downside risk is limited. This theory can greatly enhance even a momentum trader's decision-making process and is somewhat proven today.

Stocks touting very high valuations are typically the love of the high momentum crowd and can often become extremely overvalued vulnerable to downgrades and negative news. For an extended momentum stock, the last buyers are likely very weak hands so the first whiff of problems sends them scurrying for the exits. FFIV is currently down -7.2%, ARMH -2.9% and CRM -6.3%. Compare this price action to GOOG down -0.9% and AAPL down -0.3% compared to a Nasdaq down -0.6%.

Basically I conclude that I chased stocks that carried no margin of safety and exposed myself to a level of risk not present in other plays. I should have bought more GOOG and never should have let AAPL run without me. Instead, I picked up other overvalued stocks ignoring their very rich valuations and was run over today in the stampede for the exits today. Yet, I respected my stops and I live to fight another day!

Brandon R. Rowley
"Chance favors the prepared mind."

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