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Wake-Up Calls Often Come Too Late

July 16, 2012 | About:
There have been investment bubbles for as long as there’s been trading. Tulip bulbs, the South Sea Trading company, technology shares, Internet stocks, etc. The one common denominator is the concept that with these wonderful and unique opportunities — valuation doesn’t matter.

Monday’s disaster du jour was Green Mountain Coffee Roasters (GMCR) which plunged about 9.5% to close at $17.82. This is a stock that peaked at $115.98 less than 10 months ago. At that high point it was valued at almost 50x that moment’s expected fiscal year 2012 EPS of $2.37. Of course it was only 38x fiscal year 2013 estimates of $3.05 if you believed the good times would keep on rolling.

gmcr-jan-2011-jul-16-2012-source-bigchar

At Monday’s close GMCR is now offered at less than 10x the newly lowered estimate of $1.80 for the fiscal year ending September 30. Fiscal year 2013 is now projected to come in at only $1.64 per share. Analysts attribute their reduced numbers to the expiration of their K-cup patent this fall which will allow for generic competition. This was certainly not an unpredictable event.

One year ago NetFlix (NFLX) was flying high at over $304 per share. That was 73x NFLX’s $4.16 in 2011 EPS. The stock cratered by almost 80% to a low of $62.40 before year-end. nflx-jan-2011-jul-16-2012-source-bigchar

More recently, Soda Steam (SODA) fizzed upwards from under $30 to $79.72 just before plummeting back to under $30 again. At the top buyers were gladly paying about 37 times the current full year 2012 estimate of $2.17.

soda-jan-2011-jul-16-2012-source-bigchar

There’s nothing inherently bad about any of those three companies. The lesson to be learned is that paying too high a valuation leaves you at serious risk of a big decline. Momentum stocks are exciting and very seductive. They’re almost impossible to play with safely.

Look again at the three charts to see the frequent gap down openings. Stop-limit orders wouldn’t have helped you. Pure stop-sells would have gotten you out, but often at way lower than your trigger prices.

I’d advise passing on these types of stocks completely. You’ll never lose one penny by not owning a stock that goes up. It’s much more fun watching these from afar while saving your investment dollars for more predictable plays.

About the author:

Dr. Paul Price
http://www.RealMoneyPro.com
http://www.TalkMarkets.com

Visit Dr. Paul Price's Website


Rating: 3.9/5 (15 votes)

Comments

The Science of Hitting
The Science of Hitting premium member - 2 years ago
"Analysts attribute their reduced numbers to the expiration of their K-cup patent this fall which will allow for generic competition. This was certainly not an unpredictable event."

These are the same people who were part of the euphoria that led to the $100+ stock price; those two sentences sum up the worth of the majority of the analyst community in a nutshell. Thanks for a great article!
gwhite
Gwhite - 2 years ago
I agree with you and the comments by The Science of Hitting. Graham and Buffett aren't considered some of the best for no reason.
V Investor
V Investor - 2 years ago
A good portion of this has to do with technical traders and momentum traders -- get in before it goes up and get out before it drops. I wonder how many people were buying Netflix at $300 on a value basis?
Adib Motiwala
Adib Motiwala - 2 years ago
Examples are good. However, equally damaging to investors are stocks that looked cheap on a trailing basis and have come off as the 'E' in P/E fell through the floor. Examples that come to mind

RIMM, NOK, RSH and maybe some more...

How does one distinguish those and avoid those?

The ones you mentioned were easier to avoid as on a trailing basis they looked expensive not only on P/E but other metrics like P/FCF, EV/EBIT etc. However, the list i mentioned did not....

gurufocus
Gurufocus premium member - 2 years ago
Avoid margin decliners:



For all three companies mentioned by Adib, their gross margins declined way before the collapse of stock prices.

Again, buy those with moat. One of indicators of moats is sustainable profit margins. Didn't we hear this many times?

GuruFocus will release a feature of warning signs, which will warn you if a company's gross margin is in decline.

vuasu
Vuasu - 2 years ago
Big thanks to Gurufocus for the great comment above!!

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