When Hot Stocks Get Too Hot Too Handle

Takeaways

• Why they are too hot to handle

• Past examples which ended badly

• How to avoid getting caught up in the euphoria

What are hot stocks?

Hot stocks are ones which are often in the headlines due to their brand name being instantly recognisable. Their stated business resonates with the layperson on the street, who often without research feels confident enough to buy their shares. This leads to these shares appreciating very quickly and becoming overvalued stocks.

Money has poured in to the stock market, driven by retail investors who think the only way is up. There seems to be little realisation that what goes up can come down. Often the hottest stocks become the most volatile stocks.

Other investors have also got involved because there is no yield on cash and are looking for some form of growth from their cash/assets. Worryingly this has led to many investors momentum trading stocks rather than investing in them.

Trading is buying and selling over a short period without actually researching the company. Investing is going through the financial accounts, understanding the firms strategy and who its management are.

Tales from the past

Several years ago, before mobile phone banking became standard, Monitise was seen as a pioneer.  Investors would sit at its conferences to hear about growing number of users and how exciting the future was. The share price reacted in kind by rising at ever greater speeds. Problem is everyone seem to forget it was not making any money.

Soon enough this realisation hit markets and the sell off in the shares left them worth virtually nothing. Yet at the time it was seen as a darling of the British tech industry. Be wary of companies who promise the world and go through endless funding rounds only to be worth nothing at the end of it.

Even seasoned professionals lose with hot stocks

Quindell was another hot stock which investors poured into, including professional investors, without doing their fundamental analysis of it. When it's creative accounting was exposed, the shares sold off brutally when a short seller exposed a short position in them.

Even portfolio managers do not do their homework.

Cue panic scenes, where portfolio managers with considerable experience running back and forth to the dealing desk trying to dump the shares and being told there was no market in them.

Just because someone is portfolio manager with all the qualifications to match and wearing an obligatory Hermes tie, does not mean they know what they are doing. Do your homework with stocks. Always. 

Enter the dragon's den

An excellent way to learn how to avoid the pitfalls of hot stocks is to watch the BBC's Dragon's Den. Business owners who are seeking capital to grow their companies present their business idea to a panel of investors. These investors have capital to deploy but will only do so if they sense a opportunity to make a return on their capital.

Many business owners come in with great tales as to how amazing their product is with fantastic tales of future sales. Only for the dragons to knock them back down to earth with forensic financially related questions. These are the kind of questions you should be asking yourself before you buy any stock.

Doing so will ensure you buy stocks on merit, not because everyone else who have not done their homework has jumped in. The financial performance of a business is what drives stocks. Over a period time, even years, a stock can fool investors about its true nature, but eventually the truth does come out.

Conclusion

Hot stocks may be what attract you to becoming an investor for the first time, but loosing money on them will often be stop you in your tracks. Too often their volatility means you buy too late and lose out to hedge fund managers. You are better off watching and learning from hot stocks.

Focus your attention on buying other less sexy names who have a small amount of debt, consistent sales, with a core product that clients need. These slow burners are the ones which eventually become hot stocks when everyone realises they have overlooked them. That will be your time to sell (at a profit) and find a sector rotation which includes some other undervalued stocks.