The Cult Stock Pattern: Is This Stock Now a Buy?

At some point, every "cult stock" goes through a period in which investors recognize its overvaluation, causing the stock to fall. In some cases, however, this drop in price can present a worthy investment opportunity at a good value. After it cut guidance yet again, is Outerwall (NASDAQ: OUTR  ) now a buy?

The cult explained
A "cult stock" is defined as having a large investor following despite somewhat unimpressive fundamentals. We have seen companies like LinkedIn, Tesla, and Workday, among others, fit in this category. These stocks continue to tick higher, often beyond reason, until the lowering of guidance or a change in perception sparks a drastic fall.

A drastic fall
Green Mountain Coffee Roasters (UNKNOWN: GMCR.DL  ) and Netflix (NASDAQ: NFLX  ) are two of the most high-profile cult stocks to fall in recent memory.

In the five years prior to August 2011, Green Mountain soared 3,500% with explosive year-over-year growth of more than 100%. However, fears of lost patents, high inventories, and slowed growth pushed shares from more than $100 to less than $20.

Netflix had also seen an impressive rally in the years prior to August 2011, boasting 50% sales growth, but then it fell from $300 to less than $70 in just four months. Most notably, fears of slowed growth, margin decompression, and high content costs led to the decline.

The realization: This stock ain't so bad after all
What's funny about these cult stocks is that beneath their inflated valuations lie pretty solid companies. Therefore, in the case of companies that have followed the cult pattern (Netflix, Green Mountain, Questcor Pharmaceuticals, etc.) have also seen a period of realization, or post-fall gains.

Both Netflix and Green Mountain now trade at pre-fall levels but with a different look. Today, Netflix and Green Mountain are experiencing low-double-digit growth, and impressively, their margins have risen. These two companies have eased many of the concerns that led to their fall.

Seeking a second pop
Essentially, the cult-stock fall gives the fundamentals time to reflect on the stock. Then, stocks are more attractive from a valuation point of view. Netflix and Green Mountain, valued at a respective 4.5 times sales and three times sales, are much cheaper than they were in 2011.

Now, for value investors, this post-cult space appears to be a good place to seek opportunity. In particular, Outerwall really sticks out to me.

Outerwall is currently at about $48, down significantly from its 2012 high of more than $70. It recently plummeted after it lowered its guidance; the company is now forecasting full-year revenue of $2.3 billion and earnings of $4.92 per share. While both figures are significantly lower than expectations, they still represent year-over-year growth.

Moreover, if we use the company's new guidance, the stock now trades at 0.5 times guided sales and nine times earnings. Both metrics suggest value, and because of its cheapness, the stock has the possibility to recover from its large fall.

With that said, it is hard to draw a positive from Outerwall's recent guidance. Thus pessimism is likely to follow the stock for some time. However, once the negativity dies down, I'd watch the stock closely and expect a second rally.

Final thoughts
While most investors consider themselves fundamentalists or technical traders, the best investors realize that both disciplines must be respected, along with the psychological trade of the market.

Retail investors often overcomplicate their analysis and forget the basics of investing. One of these basics is that valuation is dependent upon expectations, meaning that a company's valuation will fluctuate until expectations align with fundamental performance. When expectations exceed fundamentals, a stock falls, but when fundamentals exceed expectations, a stock rises.

Now, Outerwall has set its expectations ultra-low, therefore the stock has fallen. With a cheap valuation and a low bar, however, this is a company that could rebound nicely over the next year. In a market that's trading near all-time highs, this is a value play that you may want to explore.

The Future of Television
Americans reportedly spend nearly 34 hours a week watching television. With television viewing taking up almost as much time as the average work week, the potential for profits in the space is enormous. The Motley Fool's top experts have created a new free report titled "Will Netflix Own the Future of Television?" The report not only outlines where the future of television is heading, but offers top ideas for how to profit. To get your free report, just click here!

Read/Post Comments (2) | Recommend This Article (5)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 19, 2013, at 5:08 PM, laKitKat wrote:

    if your pushing Outerwall, it would be helpful to at least tell us a little more about them than recent guidance and price moves--what they do and how well the do it would be a good start.

  • Report this Comment On October 05, 2013, at 3:43 AM, CoreAndExplore wrote:

    Well that was some incredible timing! Nice article.

Add your comment.

Compare Brokers

Fool Disclosure

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 2645987, ~/Articles/ArticleHandler.aspx, 9/30/2016 11:55:22 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Today's Market

updated Moments ago Sponsored by:
DOW 18,314.66 171.21 0.94%
S&P 500 2,168.34 17.21 0.80%
NASD 5,310.30 41.15 0.78%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes

Related Tickers

12/31/1969 7:00 PM
OUTR $0.00 Down +0.00 +0.00%
Outerwall CAPS Rating: **
GMCR.DL $0.00 Down +0.00 +0.00%
Keurig Green Mount… CAPS Rating: **
NFLX $98.19 Up +1.52 +1.57%
Netflix CAPS Rating: ***