What can Tesla (NASDAQ:TSLA) teach us about momentum investing? Since its 2010 initial public offering (IPO), the electric car company has rocketed to ever-growing heights. $10,000 invested in the company would have grown into $1.28 million today.

But these eye-popping returns usually elicit feelings of “could-have-but-didn’t.” In other words, how many people do you know who became multi-millionaires by investing in TSLA? Unless you’re friends with the Tesla executive team, the answer is likely “zero.”

Why? That’s because momentum investing is one of the most challenging investment styles to master. (And this is coming from an investor who specializes in it.)

In my experience, I’ve found that investors usually do one of the following:

1. Sell out too early.
2. Buy too little of any company to make a difference.
3. Miss the opportunity entirely.

So, how can investors stop missing out on the next 1,000X stock? Here are five critical lessons that Tesla teaches us about good momentum investing.

Momentum Investing Lesson #1: Buy the Clear Winners

How do you even begin finding the next Tesla? Today, there are 6,000 companies listed on the NYSE and NASDAQ exchanges. If you include over-the-counter stocks (also known as pink sheets) and international companies, the number balloons to over 41,000. Even professional investors often don’t know where to start.

Here’s how to beat the experts: buy the clear winners.

Take electric vehicles, for instance. Back in 2009, Tesla had one primary competitor: Fisker Auto. At the time, both companies seemed quite comparable; Tesla got its start from a $465 million low-interest loan from the U.S. Department of Energy, while Fisker received a $529 million one. But, those in the know started to suspect something was wrong at Fisker. While Tesla’s reviews and battery design flaws received some negative press, Fisker got pushed into the deep end.

“Where press is concerned, Fisker has garnered more than enough dents over performance issues with the Karma,” Inc writer Jeremy Quittner reported in 2012, “including a car bursting into flames and the vehicle failing to perform for Consumer Reports, to relegate it to the salvage yard.” Fisker would continue struggling and eventually go bankrupt after a massive battery recall by its supplier. Tesla, meanwhile, would rank among the top ten most valuable companies.

Now, the “winner-takes-all” rule doesn’t always apply. Successful duopolies can last years (or even indefinitely) – Oracle (NYSE:ORCL)/Microsoft (NASDAQ:MSFT), Chevron (NYSE:CVX)/Exxon (NYSE:XOM) and Coke (NYSE:KO)/Pepsi (NYSE:PEP) are all pairs that have performed reasonably well. But when it comes to momentum investing, it’s usually better to buy the more established company. That’s because, if a duopoly fails, you want to hold onto the company that will survive.

Lesson #2: Look at Stock Price, Not Earnings Growth

The past 70 years of data show that stock prices (not earnings growth) are a better predictor of returns. The conclusion might seem counterintuitive at first – earnings should ultimately dictate stock price. But in practice, investors do the opposite.

“Price momentum, particularly with large-capitalization stocks, conveys different information about the prospects of a stock and is a much better indicator than factors such as earnings growth rates,” wrote fund manager James O’Shaughnessy in his book What Works on Wall Street. “First, price momentum is the market putting its money where its mouth is. Second, the common belief that stocks with strong relative strength also have the highest price-to-earnings (PE) ratios or earnings growth is incorrect.”

Academics might turn their noses. But in the real world, Tesla stock followed this guide to a tee. Operating losses ballooned during Tesla’s highest-growth years between 2013 to 2017 when it scaled up its Model S production. Loss per share went from negative -$0.06 to negative -$2.09. Its market capitalization, however, almost tripled during that period.

High potential companies often sacrifice short-term earnings for long-term gain. Adobe (NASDAQ:ADBE) did that in 2013 as it switched users to its highly lucrative Creative Cloud suite. Amazon saw minimal earnings growth for much of its years. It pays to hold on.

Lesson #3: Avoid the Most Expensive Companies

There’s a misconception that momentum stocks are also expensive on the four primary valuation ratios:

• P/S: Price-to-sales
• P/CF: Price-to-cashflow
• P/BV: Price-to-book
• P/E: Price-to-earnings

But that’s not always the case. And as Tesla stock teaches us, it’s best to buy high-momentum stocks when they’re cheap. (Conversely, avoid momentum stocks when they’re expensive)

Consider Tesla in 2011 when its shares were expensive. That year, its P/S ratio stood at 14.0x, a princely sum for a money-losing startup. Shareholders would have earned 0% gains as valuations caught up. By 2019, Tesla’s P/S ratio had fallen to just 3.0x. The company would return 440% to shareholders the following year.

Mr. Shaughnessy found the same conclusion when working with larger samples. Various momentum strategies he used “almost always works best when you include a value factor in the model.”

Lesson #4: Hold On

There’s one downside to momentum investing: it’s also one of the most volatile strategies.

According to data from the Kenneth French library, pure momentum strategies had an 80% drawdown during the 2009 global financial crisis. And these swings make momentum strategies extremely difficult to stick with, even though they tend to win in the long run. Tesla has seen its share of volatility too. Since 2010, Tesla has seen drawdowns (peak-to-bottom losses) of 35% or more on 12 separate occasions. And in March 2020, the stock dropped 63% from its previous high. Each time it’s fallen, investors should have bought, not sold the stock.

So, how can investors tell the difference between a temporary dip and a permanent fall? It depends on the length of the decline. In Tesla’s case, the stock took 18 months or less to recover in all but one instance in 2017.

When dips last longer than 18 months, investors should sell, especially when people had ignored Lesson #3: valuation. For instance, in the massive 1999 tech bubble, Amazon (NASDAQ:AMZN) shares rocketed to a nosebleed 45 times P/S ratio. In the 18 months following its December 1999 peak, AMZN stock cratered 85% to $15. Investors would have been better selling out before the stock dropped another 60%. (They could have re-bought later once momentum indicators had turned positive again).

Lesson #5: Look Out the Window

When in doubt about a momentum company, look out the window. Do you see the underlying company doing well? Are Teslas driving up and down your street?

Stocks don’t exist in a vacuum. Instead, they tend to track the firm they represent. Put another way, a company that’s doing supremely well tends to have higher-performing stock. (There are always exceptions, particularly in value investing. But it’s rarely the case in growth/momentum investing).

Tesla exemplifies this “look-out-the-window” principle. When the Model S launched in 2012, the car was so popular that buyers often had to wait almost a year for delivery. Forum sites popped up with people comparing wait times. It’s marketing that no money could buy.

Apple (NASDAQ:AAPL) saw a similar demand with their iPhones. Even the eleventh generation of iPhones released in 2019 saw overnight lines out the door. And its stock has gone up accordingly.

Conclusion: Momentum Investing

When buying momentum stocks, it’s often tempting to chase the most popular, most expensive companies. Zoom Communications (NASDAQ:ZM) and Shopify (NASDAQ:SHOP) both have price-to-sales ratios over 30x, for instance.

But the data tells us to do otherwise. Instead, we should use the lessons of Tesla stock investors.

If you’re looking to dive into momentum investing, be sure you’re buying the top-dog companies on the cheap. For example, Carvana (NYSE:CVNA) trades at just 2.6x P/S (and has a 190% 12-month gain). First Solar (NASDAQ:FSLR) has a similar valuation and an intriguing turnaround story.

These are not always the most comfortable companies to buy. But as Tesla’s formative self shows us: great investing can involve making difficult decisions. And it pays to get things right.

On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.