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The Death of Cool Equities

Mar 16, 2016

Wall Street's trendiest companies are finding out what fashionistas have known all along: One day you're in, and the next day you're out. Take Tesla Motors , the $29 billion electric-car maker run by a real-life Tony Stark. The stock has trounced the market every year since going public in 2011, yet it's down 18% since August. The same goes for Chipotle and Shake Shack . Once craved by Wall Street traders and famished millennials alike, these locally sourced fast-casual joints have lost about a third and half of their value since the summer, respectively.

So what exactly does the market covet these days? Pretty much the exact opposite. For instance, Hormel Foods , the stodgy meat processor that brings you Spam, has seen its stock soar 49% since the start of August, even in the midst of a major market pullback. Shares of Waste Connections , which has zero buzz on social media—the company collects municipal trash in small cities and suburbs—have also zoomed 29%.

Call it the death of cool, a cool off, or simply a "regression to the mean," but stocks of trendy companies have suddenly fallen out of favor. These companies—many of which are trying to disrupt their industries, be it tech or media or hamburgers—are partly victims of the shaky markets.

Investors see gyrations in the Chinese economy and plummeting oil prices as canaries in the coal mine for a possible global recession. That would make life tough for all companies, but especially for untested outfits riding on buzz and potential, as opposed to profit growth. That's why in times like these, investors often hitch their wagons to established players with steady, if unspectacular, earnings.

"Boring companies are doing better because they are less volatile in a volatile market," says Leah Miller, chief executive of Red Anchor Wealth Management, in Charleston, S.C. What's more, cool stocks generally don't pay dividends, which scared investors usually crave.

Of course, this reversal of fortune could simply be overdue. By the time Wall Street spots a trend and gets around to exploiting it, the fad has usually jumped the shark. In January one fund company filed plans to launch an ETF that, you guessed it, tracks stocks with social media buzz to invest in what's cool.

That probably means the cool kids' party is over. Here's how you can profit in a market that's suddenly less enamored of shiny toys:

Look for more cool shoes to drop

The only things this market hates more than cool and trendy stocks are ones trading at triple-digit price/earnings ratios. So watch out for Netflix . The streaming-video giant and content producer entered January riding high, after beating the market by 133 percentage points in 2015, and nearly quadrupling in 2013 (the stock took a breather in 2014, sinking 7%). But even after dropping 15% this year, Netflix shares are astonishingly expensive, with a P/E ratio that's about 11 times higher than that of the broad market (see chart).

Sure, the company is growing, and revenues are up 55% since 2013. But costs are rising too. This is partly an unintended consequence of Netflix's own success. Now that the company has established a market for streaming video, more and more competitors—like old media leaders such as HBO—are offering similar services. That competition for content will likely boost expenses as competing bids for programming could drive up prices. Netflix's push to expand overseas could also boost the company's costs. "Netflix expects to continue to burn cash at an increased rate for the next several quarters," notes Wedbush analyst Michael Pachter.

INV_cooling_graphic

Perhaps more troubling, Netflix's U.S. subscriber growth has disappointed lately, so this is no fallen angel that you should expect to bounce back quickly.

Embrace the boring

The corollary to the death of cool equities is the rise of boring stocks. And you can't get more humdrum in the fast-food world than the Golden Arches. McDonald's struggled mightily between 2012 and 2014 as newer and hipper eateries like Chipotle, Shake Shack, Habit Burgers, and Noodles & Co. became increasingly popular.

In the past year, though, the narrative began to shift after Chipotle was hit with an E. coli crisis, McDonald's hired a new CEO, and Mickey D's customers started getting Egg McMuffins around the clock. Not only did the all-day breakfast juice same-store sales, but the successful launch is a sign the company is overcoming past execution problems, says Morningstar analyst R.J. Hottovy.

To be sure, MCD isn't exactly a bargain. After the stock soared 31% over the past year, its 22 P/E ratio is higher than the S&P 500's. But the stock has still trailed the market over the past three years and is cheaper than Shake Shack, Chipotle, Wendy's, and Restaurant Brands International, parent of Burger King and Tim Horton's.

Read next: Why You Should Invest Like Your Grandparents

Plus, McDonald's is in the S&P 500 High Quality Rankings, an index of companies with strong balance sheets, steady earnings, and low debt—exactly the type of stocks that thrive in rocky markets. In the Great Recession of 2008, Mickey D's returned 8% while the market sank 37%.

Don't care to buy individual stocks? You can capture established names such as McDonald's and Hormel Foods through PowerShares S&P 500 High Quality Portfolio . The ETF tracks the S&P 500 quality index and is in our MONEY 50 list of recommended funds. Or go with SPDR Global Dow ETF , which owns shares of the biggest industry titans—many of which happen to be boring, such as McDonald's and Procter & Gamble.

Hunt for fallen angels carefully

At first blush, the fact that Chipotle continues to sport an above-average P/E—after losing about a third of its value—may be a sign that investors still think it's special. It also means, however, that the stock remains frothy.

And now investors are beginning to wonder if the stock deserves to trade even at these levels. "We question why Chipotle of today should be valued like Chipotle of yesterday," notes Deutsche Bank analyst Karen Short. While management has put into place safeguards to prevent another E. coli scare, "there is tremendous uncertainty on how well they will be received," she says.

Even before the health crisis, Chipotle was earning less per location than Shake Shack, whose profits are forecast to grow faster than Chipotle's over the next five years. And then the chain suffered as big a drop in consumer perception as General Motors did in 2014 when it had to recall millions of faulty ignition switches, according to the YouGov Brand Index.

As for a stock that seems hyped but really isn't, check out Twitter . Though it's considered part of the "in" crowd, Twitter has actually been treated more like a geek by investors. Following a brief one-month honeymoon after going public in late 2013, the micro-blogging site lost three-quarters of its value. Yes, Twitter boasts 305 million monthly active users, but today that trails Facebook (1.6 billion) and Instagram (400 million). Can you say #fail?

Read next: 3 Ways Facebook is Crushing Twitter

But now that all the sky-high expectations have been completely dashed, there's a positive case here. For starters, Twitter is finally on the verge of turning an actual profit, a big step for a social media stock. Advertising revenue in the U.S. and internationally grew by almost 50% compared with a year ago, and more companies are advertising on the platform than ever before. "We see Twitter as an opportunity in the making," says Mike Desepoli of Desepoli Wealth Management in Port Jefferson, N.Y.

The challenge: The company's "current strategy is adequate to retain users, but inadequate to attract new ones," says Wedbush's Pachter, who has a neutral rating on the stock. So as Facebook did a few years ago, Twitter needs to find a way to get its customers' parents to create a handle.

Broadening your appeal from early-adopter millennials to Gen Xers and boomers is exactly how to lose buzz. But in this market, that may be the best way to go.

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