Winners Keep On Winning: Investing In Outperforming Stocks

Many investors tend to stay away from stocks that are appreciating strongly over time, mostly because of fears of buying too late when the stock is already overvalued. Having some patience when looking for entry prices and being conscious about valuation is very important. However, blindly avoiding stocks with vigorous momentum can mean that you are missing many of the most profitable opportunities in the market.

Momentum and valuation can be remarkably different things, and the best companies in the market can sustain massive outperformance over long periods of time.

Winners Keep On Winning

When a stock is rising strongly, many investors tend to think that it is already too late to buy. In cases when you consider that the valuation is not justified by the business fundamentals, being patient and waiting for a better entry price is in fact the smart thing to do.

On the other hand, avoiding a stock only because its price is rising can be one of the most expensive mistakes that you can make as an investor. The most important thing to consider is that only because the stock has appreciated this does not mean that it is overvalued.

Momentum is about comparing the stock price versus its price in the past (absolute momentum) or versus other stocks in the market (relative momentum). Valuation, on the other hand, is about comparing the price of the stock versus the value of the cash flows that the business is expected to produce in the long term.

Sometimes the stock price is rising because the value of the business is increasing. A clear example could be the internet and software companies that are currently benefiting from accelerating revenue growth during the pandemic. Some companies are particularly successful at building new growth engines over time, which obviously increases the value of the business.

Amazon (AMZN) is a paradigmatic example to consider. In April of 1999 Amazon was considered "by far the market's most overvalued stock, according to a survey of eight leading Wall Street strategists". The stock was trading at $168 per share back then versus over $2,411 per share now. The stock price actually collapsed during the explosion of the dotcom bubble, but this shows how valuation can look very different depending on the timeframe.

More recently, there are many examples of analysts considering Amazon overvalued at much more reasonable valuation levels in the past decade. A Forbes article from 2013 calls Amazon "One Of The Most Overvalued Stocks" in the market at a price level of $358 at the time.

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Disclosure: I am/we are long DOCU, AMZN. I wrote this article myself, and it expresses my own opinions.

Disclaimer: I wrote this article myself, and it expresses my own opinions. I am ...

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