Chapter 3: Advanced Market Analysis
What is momentum
Momentum, in a physical sense, refers to an object that already has significant force behind it, making it easier for it to continue moving. In the stock market, momentum has two similar meanings.
First, a stock can have momentum if a large number of people are buying into the company, which increases its appeal, attracting even more buyers and driving up the stock price further.
Second, momentum can apply to a company itself. For example, if a company is generating strong revenue, it can reinvest that money to grow even more. Alternatively, if a company has a great reputation, it can capitalize on that to secure better opportunities, further enhancing its reputation and success.
Why is it such a powerful force
A great example of momentum's power can be illustrated with two companies, A and B. Let's say Company A starts out making $40 million per year, while Company B starts out with $50 million per year. That extra $10 million allows Company B to invest in a better marketing strategy.
The next year, Company A grows its earnings to $45 million by reinvesting some of its profits, but Company B, benefiting from its marketing boost, now makes $65 million. In the following year, Company B uses its additional $20 million to improve its manufacturing process, leading to even greater efficiency.
By Year 3, Company A is making $50 million, but Company B has surged ahead to around $100 million.
While this is an extreme example, it clearly shows how momentum, when leveraged correctly, can provide a massive advantage, allowing a company to accelerate its growth and outpace competitors.
How to use it for your advantage
Understanding how momentum works also highlights the risks of going against it. Even if a company has a solid business plan and a great product, a recent hit to its reputation can snowball, leading customers to speak negatively about the company, which can undermine the advantages of its good product. This illustrates the danger of moving against momentum.
However, it's also important to be cautious when moving with momentum. It’s often overdone, and when a stock's price soars without the underlying numbers or fundamentals to support it, the stock becomes vulnerable. If the company then encounters a problem, the stock price could plummet dramatically. This dual nature of momentum, its potential to drive success, and its capacity to amplify risks, require careful consideration when making investment decisions.