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The Scary, Exciting, Risk-Laden, Lucrative World of Fallen Angels

Wall Street today is like a field of battle littered with wounded tech stocks shot down by disappointing earnings or, in the case of most Net stocks, no earnings. If stocks were people, this would be a tragedy. But they are not, and this unpleasant sight in fact offers opportunity for investors.

Fallen angels. Turnarounds. Call them what you will, good companies that have stumbled and been trampled by the mob should always be considered by real investors. They can be home runs. They can be utter strikeouts. But if you are going to make money over the long haul, you need to move when the market offers you the chance. You should learn how to spot beaten-up stocks -- typically down at least 50% from their peaks -- that can recover. Tech today may offer such opportunities.

You cannot rely on Wall Street analysts and financial journalists to provide too much help in this matter. The same seers who failed to give you the heads-up before the fact tend also to be the ones who pull their buy recommendations or write the oh-the-pity-of-it-all stories after a company announces bad news. Read what they say but learn how to spot good bets on your own. This is tricky stuff and not for the fainthearted.

I talked with one forty-something growth stock investor who's had a fallen-angel partnership for more than five years, in that time compounding his investors' money at slightly more that 25% a year. So far this year, the fund is up slightly. He doesn't go short. He doesn't use enormous leverage. He tends to hold for at least one year so that his clients can get tax-advantaged long-term capital gains.

"I will tell you how we do it," he says.

The Crucial Competitive Edge

First, make sure the company still has its competitive edge. "Because we are growth investors, we find ourselves often in looking in the technology area," he says. "Because technology changes quickly, we are trying to find companies that despite their recent problems retain a unique, proprietary business franchise. The technology must still be cutting-edge.

"If the company still has the best technology, then there will not be a lot of competition and pricing pressure," he goes on. "That gives management financial breathing room to fix the problems. They can spend more on R&D and reallocate capital within the business without murdering profit margins."

This is especially important when investing in tech, where rapid change is a constant. A company can stumble and never recover.

He has a watch list of companies that had terrific businesses before the stumble and may still. He has, for instance, taken small positions in two troubled software companies -- Legato Systems (LGTO) and Citrix Systems (CTXS - Get Report).

A Pair in Pain, but With Prospects
Legato Systems and Citrix Systems, one year

"Legato collapsed first on terrible earnings," he says. "The company claims it had rogue salespeople who overstated sales. Then it was late filing its 10-K and dropped further. It has lost a bunch of midlevel executives and salespeople and the company is up against a fierce competitor in Veritas (VRTS) -- nothing unusual in these kinds of situations. Many think the company cannot recover. But the business of selling backup software for network storage systems was terrific before and I think they will survive the current difficulties."

A Board That Cans More Than Peaches

Citrix, he says, exemplifies another thing he looks for -- a board that moves quickly to solve the problem.

"CTXS announced disappointing earnings about a month ago," he says. "The board immediately revamped management, which was the right thing to do. They responded immediately. One missed quarter and they shook it up. This company sells software that allows multiple users to use Windows NT on a single server. This had been a great business with great operating margins -- around 40%.

"I think they can fix the problems facing them in part because they have the financial cushion, but also because the board has moved quickly to solve the problem."

The Ability to Reinvent

A third thing he looks for is a company that can reinvent itself.

"If a company's basic business is dead, they have to abort and go forward with something cutting edge," he says. "One company that has done that I think can do that is Parametric Technology (PMTC), which was famous for its engineering CAD-CAM software, a business that has matured. But the company has a new product called Windchill, Web-based collaborative design software, a state-of-the-art product that uses the Net to link design with manufacturing and purchasing. They hope it will provide the growth going forward, and I think they have a good chance of succeeding."

Time to Adopt the 'Metric System?
Parametric Technology, one year

Earnings Disappointments, but Not Too Big

He also looks for stocks with "minor" earnings disappointments. "Make sure it is minor," he says. "The trick is to make sure that it is not simply the first of many problems. That is not always easy to do. It takes work and time. But the beauty of fallen angel investing is that these stocks rarely snap back immediately. It takes months or a year once a company disappoints. So you have time."

One smashup du jour that intrigues him is Pinnacle Systems (PCLE). Pinnacle plunged 59% Tuesday after the maker of video-editing tools reported profits about half what analysts had expected. It edged back up 2.7% Wednesday.

For Now, Far From the ... You Know
Pinnacle Systems, one year

This guy has made money on the stock before and thinks there may be a chance again. "I bought this at about $6 a share last year and sold two-thirds of the position at a healthy profit." The stock peaked in March around 36. "I am waiting to see what the company and analysts say about the problems before doing anything. But this is a candidate for the fund."

If you try this game, don't wait too long. These stocks can do round trips to nowhere if you are not careful. And be sure to diversify. Not all of these will work out.

A Web Full of Fallen Angels -- Which to Buy?

You might wonder what this guy thinks of Net stocks. He is looking at them on a case-by-case basis. Right now, he is looking at shares of Internet-based employment recruiting companies.

"I think it makes sense for classified ads to move to the Net," he says. "The Internet is efficient for this purpose. And I think the job market will remain tight. All the stocks are well off their highs."

His picks? (HOTJ) and CareerBuilder (CBDR).

Na-Na Na-Na, Na Na Na Na Na -- Get a Job
CareerBuilder and, one year

"They say they will be profitable by late this year or early next year. I think they have the cash to make it to profitability given their burn rates," he says. "But these are small positions because they may disappoint. Given how new these companies are, I'd call them fallen cherubs."

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