The consensus is comforting in times like now, when all investors are seeing red in their portfolios. But is running with the herd a good way to protect yourself, or are you asking to be trampled? The herd that is Wall Street has flocked to some stocks, as evidenced by their stubborn highs that remain higher than most.
Take the cloud service provider Cloudy (REPORT -9.23%); yes, the stock took its hits on the chin, dropping 72% from its peak. But look around the tech sector and you’ll quickly see the premium it’s still trading from. Here’s why the generally positive sentiment towards the stock creates a risk for shareholders.
Cloudflare against the ground
Don’t interpret this as a bearish view of Cloudflare’s business; my only goal is to help you succeed as an investor. The company offers various internet services through the cloud and looks poised for long-term success. But stock prices move like a short-term popularity contest and based on long-term fundamentals. That’s why stocks can get expensive and nobody flinches, but when they drop to advantageous levels, people run for the exits.
There are many ways you can look at the fundamentals of a business, but it can boil down to a few common themes:
- How fast is he growing?
- How much money does it bring in?
- How much do you pay for it?
See how Cloudflare compares to other software vendors in these critical areas. These companies do different things, but they are all software-based companies that generally sell their product on a subscription basis, commonly referred to as software as a service (SaaS).
The charts you see above include Cloudflare, monday.com, MongoDB, Twilioand CrowdStrike Holdings. You can see that Cloudflare’s revenue growth is somewhat average in this group; it’s not growing as fast as Monday.com or CrowdStrike, roughly on par with MongoDB, and a notch above Twilio. You can also see how Cloudflare’s cash burn is among the worst of this bunch. However, the security’s valuation measured by the price/sales (P/S) ratio is the highest. CrowdStrike is the only company valued close to Cloudflare’s P/S, but its free cash flow is clearly positive, no doubt a reason why it should be valued more than Cloudflare.
The downside of the herd mentality
An investor should see a puzzle like this and wonder if Cloudflare deserves such a high valuation. Paying a high valuation for a hot stock works until sentiment changes; hypothetically, the broader market could decide that Cloudflare no longer deserves a higher P/S ratio. Imagine growth slowing or something else happening. Matching the valuations of other stocks would mean a 50% discount to its current price!
That’s the risk of buying any hot stock on Wall Street. It doesn’t always backfire, but you need to know how different stocks stack up against valuation and fundamentals. There are many instances throughout history where stocks were temporarily popular but ended up being miserable long-term investments.
Once again, this is not a knock on Cloudflare; merely warning that its premium valuation could backfire on investors. Trying to predict the stock market is a mistake; do not do it ! Thoughts like, “Well, everyone loves this stock, so it will keep winning.” Or, “This stock has already fallen X%; it can’t continue to fall!” require a painful lesson. Remember that the stock market can be irrational in the short term, so don’t try to reason with it.
So what should you do with Cloudflare?
How to get out of it despite all the uncertainties? Maintaining a diversified portfolio of fundamentally sound businesses will greatly increase your chances of building long-term wealth. Cloudflare can undoubtedly be part of a successful portfolio, even if the stock price continues to decline over the coming weeks or months. An investment thesis can take years to materialize, so it’s usually a good idea to hold stocks for at least five years.
You can’t know for sure where Cloudflare’s lowest valuation will be. So to protect yourself, you can work your way into positions, slowly buying a little at a time to make sure you don’t jump in too soon with both feet, forcing you to watch your investment shrink in a bear market. .
justin pope has positions at monday.com Ltd. The Motley Fool has posts and recommends Cloudflare, Inc., CrowdStrike Holdings, Inc., MongoDB, Twilio, and monday.com Ltd. The Motley Fool has a disclosure policy.