Do You Love Cult Stocks?

Some of the most popular and best-performing stocks in the market over the past decade are often criticized for being “cult stocks.” The word “cult” certainly has negative connotations, but investing in a cult stock can be both extremely lucrative and potentially dangerous.

What Is A Cult Stock?

Just because a stock is popular doesn’t mean it's a cult stock. Stocks are typically valued based on fundamental business metrics reported on a quarterly basis. These metrics typically include numbers such as earnings, revenue, cash flow, margins, debt and other indicators of how well a business is performing.

In certain cases, stock valuations become completely detached from traditional metrics. The valuation of cult stocks typically revolves around a story rather than tangible numbers. Investors ignore how the business is performing and focus more on what it could be sometime down the line. Cult stocks often have charismatic CEOs who make lofty promises to investors.

The companies behind cult stocks typically are developing a revolutionary or groundbreaking product or service that investors believe has the potential to completely disrupt a massive established market. In reality, this type of disruption is extremely rare. For every Amazon.com, Inc. AMZN there are thousands of Solyndras, Jawbones, Theranos and Wongas.

A Dangerous Mentality

There’s nothing wrong with having faith in a CEO or a stock. Blind faith, however, can be a big problem. Cult stock investors tend to dismiss any negative reporting relating to a company and scapegoat short sellers or even the financial journalists and analysts reporting on the company rather than blame the company or management itself.

“The biggest sign that a company has a cult following is the deluge of nasty emails we get when any of us writes anything, and I mean anything, that might question that company's strategy,” Motley Fool contributor Alyce Lomax wrote back in 2005.

Ironically, the cult stock Lomax was blasted for questioning at the time was none other than Apple, Inc. AAPL, which is up about 1,930 percent since that article was written.

Just because a stock is a cult stock doesn’t mean its a bad investment. Some cult stocks ((Enron, OTC:HMNY), GoPro, Inc. GPRO, etc.) end up being big long-term losers for investors. Others, like Apple, Amazon and Netflix, Inc. NFLX, end up big winners.

The important thing for investors is not to avoid cult stocks. It’s only to recognize the cult stock mentality and make sure not to get swept up in it so much as to ignore the extremely high risk associated with buying a stock with questionable fundamentals and an extremely high valuation.

“When stocks fly into orbit, breaking free from all traditional valuation restraints, I have a hard time telling you to buy them,” Jim Cramer said of cult stocks back in 2015. At the time, Cramer was specifically addressing Netflix, Amazon and Tesla, Inc. TSLA.

Cult Stocks In Today’s Market

Identifying cult stocks is somewhat subjective, but a good place to start is to look for stocks with large market caps that have negative earnings or extremely high earnings multiples. Companies with negative free cash flow are also potentially cult stocks. These cult stocks often tend not to react to negative headlines as well due to their extremely loyal investor base. They also tend to have large outstanding short positions of bears that recognize the disconnect between the company’s fundamentals and its valuation.

In addition to the stocks already mentioned, here are 10 stocks in today’s market that are often classified as cult stocks due to the criteria above:

• Fitbit Inc FIT
• Grayscale Bitcoin Trust GBTC
• Federal National Mortgage Association FNMA
• NVIDIA Corporation NVDA
• Square, Inc. SQ
• Cronos Group Inc CRON
• Twilio Inc TWLO
• World Wrestling Entertainment, Inc. WWE
• Etsy Inc ETSY
• Advanced Micro Devices, Inc. AMD

Related Links:

Why The Bitcoin Bubble Is Different From All Other Bubbles

What Are Wall Street's 'Cult' Stocks?

Photo courtesy of Kool-Aid.