If I told you about a stock that was down nearly 50% in two months, you might feel bad for its investors. That is the situation Cloudflare (NYSE:NET) stock is in. However, investors are not necessarily upset, because many of them still have gobs more profits on hand. NET stock rallied well over 1,000% from the beginning of 2020 to its peak. Therefore giving back some is not only normal but necessary price action.
Nothing ever rallies continuously without rest. The alternative would be a house of cards that crumbles at the slightest whiff of trouble. Nevertheless, this dip was serious, and investors should resist going long blindly. There are opportunities today, but only by taking great care exploring them.
It is tempting to only consider the past 12 months price action. From that perspective it looks like NET stock is at an extreme low. But expanding the view to include all of 2020 makes clear that more downside can happen.
NET Stock Has Upside Potential
I don’t intend to make this a bearish note about NET stock. The company has positioned itself well for the future. It aims to help secure and facilitate inter-connectivity, which sounds like a perfect fit for the new world. According to its website, Cloudflare strives to make the internet more secure and without compromises. This should keep demand strong for its services and NET stock too.
I also acknowledge that the stock hit a support level that has been pivotal since February of last year. Therefore it is likely to find buyers lurking just below. NET rallied feverishly from $100 per share in July and then revisited it on Monday. The tech sector sell-off was pretty scary for those watching the price action that day. Therefore if the stock market holds up, NET stock has the opportunity to rally back into $140 per share.
However, I caution investors from staying too long without booking profits. If it loses the century mark, it could carry much lower and even past the $75 support. The trigger from $100 resembles a bearish head and shoulder pattern. I can give the bulls the benefit of the doubt for now. Therefore the assumption is that $100 will hold without further panic on Wall Street.
Fundamentals Suggest Upward Bias
Yesterday, Federal Reserve chair Jerome Powell spoke about raising rates, yet stocks shrugged off the comments. This is a preliminary sign that investors are coming to terms with a higher rate cycle. So the bears will need a new scary talking points to cause further damage in equities overall.
Fundamentally, Cloudflare has an enticing offering. Its financial statements show consistently outstanding growth. Since 2018, it has grown revenues and gross profit over 40% per year. That is impressive enough, so it is not necessary to look for profits yet. Those can come later, because for now growing the top line should be the goals.
Meanwhile, those looking to invest must ignore the fact that it’s expensive. The proper metric for value in a stock like this is its price-to-sales ratio (P/S). So far Cloudflare is in the stratosphere with a trailing 12 months P/S of 73. This shouldn’t be a deal breaker though, because the metric can normalize. Zoom’s (NASDAQ:ZM) P/S was over 120 at its peak. It is now just 13.5 because the company managed to have sales growth outpace the stock price.
The conclusion today is that NET dips should be opportunities for new investors. The 50% correction is enticing, but it’s definitely not a reason to go all in. This is especially important since markets are still near all-time highs and are susceptible to further downside. Sentiment on Wall Street is on edge, and the bulls have one foot out the door.
Until new bearish trends develop in the S&P 500 chart I would not assume a correction is imminent. There will be selling areas, and therein lies the risk of those effects on NET stock. A relatively easy way to deal with this is to set smaller trades and establish quick stop losses.
On the date of publication, Nicolas Chahine did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
Nicolas Chahine is the managing director of SellSpreads.com.