When it comes to picking stocks, some investors study a company’s fundamentals. These include ratios like price-to-earnings, price-to-sales and price-to-book, as well as the cash flow statement.
Others prefer to analyze a stock’s technical aspects, looking at moving averages and support and resistance levels so they can weigh the best time to buy.
But with some stocks, it’s not the fundamental or technical aspects that take center stage. It’s the story…
Saving Lives… Making Money
This is often the case with healthcare stocks – particularly the smaller names. And it’s not surprising that investors get excited about owning shares of companies with potential breakthrough drugs.
After all, who wouldn’t want to be involved with companies that are saving people’s lives or relieving suffering? At a cocktail party, do you want to talk about the S&P 500 or the $2 stock that could go to $50 if its cancer drug is approved?
It’s compelling stuff.
When I first was licensed as a Wall Street analyst, I covered retail stocks. Being a stock junkie, it was interesting. But after a while, same-store sales figures didn’t provide that rush I craved. I needed more.
Biotech provided it.
I’m half joking here. You should never invest in stocks because you need the adrenaline rush. But being a writer, and also an analyst, I always wanted to tell a story as well as crunch the numbers.
But here’s one of the downsides of a “good story” – and what to do when you become too attached to its stock…
You Hear That Voice? It’s the Voice of Reason
The primary reason for buying companies with feel-good stories is because investors want the story to result in a higher share price – and in turn, produce a sizable profit when they sell the stock.
But when you become too attached to the story at the expense of reason, not selling the stock can prove disastrous.
Sometimes we’re blind to evidence that the company or drug isn’t all it’s cracked up to be. Other times, we ignore our trailing stop discipline because we just can’t let go of the story.
The Mela Emotional Investing Story
I advised the subscribers to one of my services to buy shares of Mela Sciences on two different occasions.
- In March 2010, we grabbed a 42% gain on the stock.
- And when it fell, we bought on the dip and cashed in another 39% gain in June.
The company made a device called MelaFind, which tells doctors whether they need to biopsy for melanoma.
By June 2010, Mela Sciences had concluded Phase 3 trials on the device and planned for a Food and Drug Administration (FDA) panel review in August. The panel would then recommend to the FDA whether MelaFind should be approved.
If the FDA determined that MelaFind was effective and approved it, the device would save a lot of lives, as it would detect melanomas that physicians might otherwise miss.
But I advised my readers to pull the trigger and sell the stock.
It was a tough decision. I had followed the company for several years. I personally liked the CEO at the time and believed he was firmly committed to saving lives.
But I wasn’t confident in this market catalyst. And by the time the FDA delayed premarket approval for MelaFind in August, the stock was 50% below its 52-week high.
The stock suffered more volatility in November as it was criticized but ultimately approved by the FDA. But even finally hearing this good news, Mela investors were so wary of the roller coaster that in the end, they were ambivalent.
In 2015, MelaFind was recalled and Mela rebranded to Strata Skin Sciences (Nasdaq: SSKN).
In short, Mela Sciences’ story was as good and emotional as it gets. And by buying at the right time, we did nab a sizable gain. But when it comes to investing, emotions are dangerous.
Two Quick Steps to Becoming a Cold-Blooded Investor
When I came across some new information that made me question my original investment thesis, I couldn’t ignore it.
After issuing the sell recommendation, I wasn’t surprised to receive some emails from people saying they were going to hang on because they still believed in the company.
When I receive feedback like this from readers, I hope they make a million dollars because that would mean that lives are being saved. And if I fail to present a convincing argument against a stock, that’s my fault.
But if they’re holding on to the stock for no reason other than that they’ve become so emotionally invested in the story, that’s a recipe for disaster.
So if you’re holding shares of companies that have compelling stories and have an emotional component, take the following steps…
- Set a trailing stop: We’ve said it here many times before – and for good reason. Doing so makes the sell decision an automatic one and removes all emotion from the process.
- Phone a friend: Every so often, tell the stock’s story to someone who knows nothing about it. See what their reaction is. Listen to their questions. First, see if you can answer them and then see how well you can answer.Seeing it through the eyes of someone who isn’t already emotionally involved and has money on the line may reveal issues that you hadn’t thought of (or chose to ignore).
In conclusion, let other investors’ emotions fuel the run-up in your stocks. Just be sure to keep yours in check so that you can get out while the gettin’s still good.