Is STEC Inc (STEC) a Buying Opportunity?

STEC Inc (STEC) is a classic winning stock. It has everything you look for in an investment that can make you a boat load of money, the most important of which is a new idea and a competitive advantage built around that idea.

But sooner or later the stock exhausts itself. It reaches the limits of its opportunity or someone comes along to build the mousetrap a better way or perhaps builds a completely different mousetrap that displaces it.

But before that happens the price of the stock will factor in every possible prospect for the company’s product at the highest attainable multiple. Investors will pay up for growth and will pay up well beyond what is reasonable. This is the way the market works and astute investors use it to their advantage.

Today STEC got hit on a downgrade questioning the sustainability of its competitive advantage. Sooner or later STEC will lose its technological lead. The prospect raised today is that it will happen much sooner than the market has priced in.

The stock is suffering severely. Many investors who have massive profits are cashing out. And then there are the latecomers: people that don’t understand the rhythm of the market and bought wrong. They are scurrying for cover, selling to stronger hands, begging to be relieved of their pain.

Should you oblige them?

History says yes.

While Mark Twain told us that history doesn't repeat but it often rhymes, what does repeat and is unchangeable is human nature. People didn’t have any different tolerance for risk and yearn for reward than they did 20 years ago or 2000. And for that reason we can consult charts of winning stocks from earlier times for clues about how STEC might act from here.

First, we have to define what the market is doing. It is in a clear uptrend. Based on its behavior the last few weeks that is unlikely to change soon. It could well go through a consolidative phase but the odds of the uptrend ending quickly at this point are low. That’s important to understand because if the market were peaking we would view STEC as a short, kicked off by a hideous downside gap through the 50 MA on massive volume.

With the market in a continuing uptrend we view STEC differently. The company has not reported any news that is adverse to its earnings or competitive position. And the downgrade itself specifically says that earnings are not threatened and indeed likely to continue accelerating in the short term.

Charts of past winning stocks tell us that stocks that look like STEC, with their blend of fundamentals and technicals, often peak in a "supernova" move higher O'Neil calls a climax run. That occurs after a longer time than STEC has been on the move and we haven't seen action resembling that yet in the stock.

We don’t dismiss the possibility that the stock could bounce back reasonably quickly from here. This is only the second time the stock has come anywhere near its 10 MA weekly and O’Neil's studies indicate stocks are often buyable for snap backs on their first two revisits to this line.

But the power of the downside move, the stock’s inability to rally back and the breadth of its gain since its May break out just above $10 a share suggests to us that the stock is likely to form a base here; a period of consolidation lasting perhaps six weeks or longer.

So should you open a position today? We would and did. Because the stock could well move lower during its correction and might be “dead money” for longer than we would like we took only a one-third share. We would use a 5% stop enabling us to reassess the validity of our thesis without the pressure of being long should price continue to move against us.

Should we not be stopped out we’ll look to build the position as price recovers. That could mean we’ll add tomorrow or weeks from now. Even should we be stopped out we will be following this stock closely. It's been the market's true leader and, history argues, will continue its run. Stay tuned.