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There's an old saying about investing that the best way to make money is to buy low and sell high. However, there's also a less popular way to cash in on Wall Street via finding the best momentum stocks.
Simply put: Buy high and sell even higher.
It's not always true that cheap stocks are a bargain. Some companies are trading at low levels for good reason and are likely to see further declines. In a similar respect, some high-flying momentum stocks are pricey for good reason and are likely to be in store for continued and sustained gains.
This latter example is momentum stock investing at its core.
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Tesla exemplifies momentum stock investing
Let's use iconic electric vehicle company Tesla (TSLA) as a working example. Tesla held its initial public offering (IPO) back in 2010 at $17 a share. Adjusting for two stock splits, a $10,000 investment four years ago would be worth roughly $107,500 today.
That's a lot of money, to be sure. But if you invested 10 years ago, you would be sitting on a $280,000 nest egg.
While this example underscores that the best money is to be made over the long term, it also shows how buying a high-flying momentum stock midway through its ascent can still be very profitable, even if you're a bit later to the opportunity than others.
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How to find the best momentum stocks
Finding the best momentum stocks to now isn't always about fundamental analysis. There are a lot of high-flying stocks that don't have particularly great numbers right now. Rather, they are speculative bets on what they will become in the future.
That means taking a longer view, and prioritizing the following factors:
Sentiment: Generally speaking, momentum stocks rise because investors are excited about them. Therefore the "feelings" around a successful momentum stock are incredibly important. Though hard to quantify, sentiment can be tracked in part via consensus Wall Street recommendations on a stock. If nearly all analysts rank a stock as a Buy or have recently changed their recommendations from neutral to positive, that's a great sign.
Longer-term charts: Technical analysis of Wall Street charts and price patterns can be complex. But you don't need a black belt in charting to understand concepts like the "moving average" for a stock price that reflects longer-term changes beyond day-to-day readings.
Momentum has a natural time element to it, so you have to think beyond today's closing price and identify long-term momentum trends by investigating price and volume patterns in charts.
Comparative returns: It's easy to identify a momentum stock that has tripled in short order, but less obvious momentum investments might not be as noticeable. Make sure you're comparing returns in short-term as well as long-term windows, and vs peer companies as well as the broader market.
You may be surprised to learn that what looked like a big winner is actually just part of a broader bull market trend and isn't all that special. Or worse, you may notice it's lagging its competitors – and at risk of falling behind even if it's still seeing shares move generally higher.
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Risks and rewards of momentum stocks
The potential payday from momentum stocks is clear, particularly if you're looking at historic success stories like Tesla. But pointing to an old winner is much harder than getting in on the ground floor of tomorrow's next momentum stock standouts.
As mentioned previously, a big factor in these investments is the intangible feeling around them. That's hard to quantify, and very hard to predict.
This makes momentum stock investing very risky, and very much a leap of faith.
Beyond that challenge of identifying stocks with a difficult-to-define "it" factor, it is also important to understand that momentum cuts both ways. Just as some stocks seem to go up illogically just because investors like them, other stocks can crash and burn when Wall Street gives up on them. That's true regardless of the facts of the news cycle or hard numbers around earnings or sales.
Stocks that are prone to upside momentum are often equally prone to big moves to the downside when sentiment changes. That means if you buy at the wrong time or in the wrong stock, you could see a dramatic loss rather than the big profit you had hoped for.
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Jeff Reeves
Contributing Writer, Kiplinger.com
Jeff Reeves writes about equity markets and exchange-traded funds for Kiplinger. A veteran journalist with extensive capital markets experience, Jeff has written about Wall Street and investing since 2008. His work has appeared in numerous respected finance outlets, including CNBC, the Fox Business Network, theWall Street Journaldigital network,USA Todayand CNN Money.
