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 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 and Netflix 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.

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The article The Cult Stock Pattern: Is This Stock Now a Buy? originally appeared on Fool.com.

Brian Nichols has no position in any stocks mentioned. The Motley Fool recommends Green Mountain Coffee Roasters and Netflix. The Motley Fool owns shares of Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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