Investing

Euphoria and heartache of meme stocks – two South African examples

Many South African investors and JSE-listed companies have experienced the ecstasy and suffering of trendy shares, as illustrated by Purple Group and Renergen.

Trendy shares, often called ‘meme stocks’, gain support among retail investors through social media hype, which drives the share price up.

These share price increases are not based on company fundamentals like financial performance and growth forecasts.

While the going is good, it is very good – the share price spikes, making the company’s shareholders and management a lot of money.

However, when the hype dissipates – as it inevitably does – the share price reverts to where fundamentals explain it.

The rapid share price decline after the hype disappears is very painful for investors, and many people lose significant amounts of money in the process.

This is why many seasoned investors advise people to avoid meme stocks and base their decisions on fundamentals.

A fundamental approach to equity investing can be summarised as setting a value to a stock or instrument based on the company’s financial performance.

Simply put, the share price should match a company’s earnings and revenue performance.

  • Investors must be familiar with the company’s financial well-being to know what they buy.
  • They must put a relative price mark on the stock based on the company’s financial performance.

An easy measure is to compare the share price with its revenue/sales per share (P/S ratio) or earnings per share ratio (P/E). These are known as relative valuation ratios.

Comparing each company’s valuation ratio to its industry average shows whether a share is significantly over or undervalued – known as mispricing.

Buying mispriced shares is the strategy many super-investors like Warren Buffett and Seth Klarman used to become billionaires.

Two local examples of the dangers of investing in hyped-up meme stocks come from Purple Group and Renergen.

Below, we show what happened to these two JSE-listed shares over the last few years.

Purple Group

Purple Group achieved widespread popularity among retail investors through the EasyEquities share trading platform.

From the start of 2020 to the start of 2022, investors made over 900% in price returns from investing in Purple Group.

Most retail investors who pumped money into Purple Group did so based on the share’s momentum rather than the company’s fundamentals.

At its height, Purple Group was traded at a price-to-sales (P/S) ratio of 18 and a price-to-earnings (P/E) ratio of 114.

At that time, similar companies traded at P/S ratios between 2 to 4 and P/E ratios between 10 and 20. Purple Group’s share price was clearly overvalued.

The company’s share price was completely detached from its fundamentals. Put another way, the share price performance could not be justified by its financial performance.

Eventually, the Purple Group share price fell to where it currently trades at 80% less than its peak.

Renergen

Another good example of a stock whose share price gains were driven by hype rather than momentum is Renergen.

Renergen was all the rage, with investors anticipating massive extraction of Liquefied Natural Gas (LNG) and Liquid Helium (LHe).

From the beginning of 2019 to the start of 2022, the Renergen share price increased by over 400% as investors pumped money into the stock.

The share price became completely detached from its fundamentals as it was bought on hype and a fear of missing out.

At its height, Renergen traded at a price-to-sales ratio of 2,200 times. It was orders of magnitude higher than other mining stocks.

Its share price reverted to a more realistic valuation by falling by more than 60% from its peak.

Despite this fall, Renergen is still trading at a price-to-sales ratio of 170. Similar LNG and LHe companies are trading at P/S ratios between 0.5 and 1.3.

Unless Renergen manages to increase its revenue at least a hundredfold, it may still be in for more nosediving. 

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