Don't Get Burned by Cooling Hot Stocks

It's well known that people love a winner. Whena sports team gets hot, everyone jumps on thebandwagon. We just can't resist going along forthe ride. Inevitably, the team will cool off,because what goes up must eventually come down.When it does, you'd better not be standing in the exit.By that time, the masses will be setting out to attachthemselves to the next hot ticket item. The same istrue with growth stocks.

Barron's

According to a recent report, investorsrepeatedly lavish newly anointed stock deities withtheir hard-earned dollars because, quite honestly, theinvestments can be highly profitable. Of course, justas fans have little indication when their team mightcool down and lose 8 games in a row, not manyinvestors have the level of impeccable timing requiredto jump off the growth-stock bandwagon at preciselythe right moment.

Hot Stock Politics

Barron's

Is today's Krispy Kreme Doughnuts, which is tradingat 50 times earnings, a modern-day Home Depot?The latter saw its stock price fall from $50 to $20 followingmanagement's warning that earnings werecoming up short. Will it be long before the fresh tasteof Krispy Kreme's product suddenly goes stale? suggests a close look at the history of formerstock market darlings to gain some perspective.From 1985 to 2000, Home Depot experienced anexplosive growth in sales and earnings. Approximately1500 of its warehouse-type stores soon dottedthe landscape, and investors were rewarded with anincredible 15,000% return (before dividends) duringthat 15-year period. But when management issued alower-than-anticipated earnings forecast, the company'sstock plummeted 28% in 1 session. Althoughmanagement blamed the soft economy, was it reallythe result of market saturation?

During the mid- to late 1990s, shares of Gap stockrose steadily, from a split-adjusted 10 up to 60. But thecompany had saturated the United States with its core-brandstores, and once other merchants like Targetand JC Penney figured out the casual sportswear market,Gap saw its sales growth slide. By November2002, Gap stock was trading at around $13. It hassince climbed slightly upward to just over $19.

Inevitable Conclusions

Companies can't increase their profits at above-averagerates forever. And they can't grow faster thanthe market over an indefinite period of time. Aresearch paper published in 2001 by the NationalBureau of Economic Research found that between1951 and 1997, only 67 (3.6%) of 1833 eligible companieshad operating income above the market medianfor 5 consecutive years. Only 4 companies manageda 10-year gain streak. Even McDonald's falteredwhen it reached saturation in the United States.

Barron's

The article notes that it would not be surprisingif soaring growth stocks eventually came backto Earth. The question is, at what point does a retailerreach saturation, or at least come near the pointwhere growth comes in much smaller and less profitableincrements? There is no definitive answer, butthere are some tell-tale signs that the rose may be offthe bloom on some favorite stocks.

Noteworthy Indicators

The first indicator that a hot stock is cooling downis a slip in profit margins. A decline in earnings qualityis also cause for concern. It might be time to pull theplug when nonoperating items contribute increasinglyto growth, tax rates decline, and expenses are capitalizedat an escalating rate. Watch for balance sheet shifts,such as rising receivables or slower inventory turnover,as additional signs of an earnings slowdown.

Another indicator is management turnover or a suddenchange in corporate strategy. This could include anincreased emphasis on overseas markets or a riskyacquisition that the company makes, particularly if thatacquisition is in a noncore business. Also, when a previouslystrong stock begins to sag without explanation,chances are other investors have already figured out thatsomething's not right.