Market darlings – those stocks often discussed at dinner parties and rarely questioned as a good investment – can make investors a lot of money on the way up. But many market darlings over history have provided the costliest lessons for investors, reminders that choosing which company not to own is often more critical than choosing what
to buy.

Market darlings all share similar characteristics – they quickly increase in price, they enjoy a high profile and the valuation becomes expensive. The biggest danger occurs when investors become comfortable. If stocks start being referred to as a “safe place to be” in the market, it’s a warning sign. When this happens investors anchor their expectations, which clouds judgement should things later change.

Here’s the bad news: while market darlings can deliver handsome returns on the way up, every market darling will eventually fall from favour. If our expectations as investors are anchored, we are unlikely to read the warning signs and will find it difficult to let go – with the risk our former market darling will suffer significant price loss and weigh our portfolio down.

If something goes wrong with a stock, investors must consider the prudent strategy – for example, selling out of the stock rather than hanging on.

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But why is letting go of a market darling so hard?

Becoming comfortable with a stock creates an emotional connection. Even professional investors need to consider this possibility – plus it often takes courage to sell a market darling because the stock may still be riding market momentum upwards, regardless of underlying problems. You may look silly for a while as the euphoria continues.

But if market darlings are special on the way up, they tend to be brutal on the way down – consider Babcock & Brown and ABC Learning to name two.

The fall of Domino’s

TPG Telecom and Vocus were recent market darlings in the telecommunications industry, with both companies growing strongly until 2016. TPG and Vocus experienced difficulties in extracting the best values from recent acquisitions. These were compounded by changes in telco sector economies becoming less attractive due to the NBN structure and competition. TPG and Vocus’ share prices have fallen 37 per cent and 62 per cent respectively from their peaks in 2016.

Domino’s Pizza had a spectacular rise in share price, growing 10-fold over a five-year period to a high of $76.91 in August 2016. The stock has since fallen 45 per cent to under $50 today. Slower pizza sales growth has cast doubt over Domino’s ability to sustain the company’s high rate of growth as store penetration became more difficult and food delivery options grew with the gig economy.

There have also been dividend darlings, including Telstra. This has served as a valuable lesson in not buying a company due to its dividend alone as the share price has drifted lower.

To successfully own market darlings, investors need to stay forward-focused. Things can change, and it’s possible these stocks are being carried away on “irrational exuberance” – consider the many market darlings in the technology sector before the crash in the early 2000s or the over-leveraged, financially labyrinthine darlings pre-GFC, such as Babcock & Brown, or the commodities companies post-GFC.

If there is a change – if the balance sheet reads poorly, the stock becomes too difficult to understand or if there are problems with management – investors may need to do the prudent thing and sell rather than hang on. They need to “kill their darlings” for the good of the wider portfolio.

Investors must remember that choosing which company not to own is just as important as buying.

 

ST Wong is CIO at Prime Value Asset Management. This article originally published in the Australian Financial Review.

Source: https://www.afr.com/wealth/avoid-big-disappointments-by-killing-your-market-darlings-20181005-h16ae0

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