Longtime value investors will say that sometimes you just know sentiment is about to turn on a stock. Unfortunately, not every investor knows what to look for. For that reason, I've developed a short list of four events that often signal an imminent price drop. Read and learn from it -- I guarantee it'll save you a pile of money.
Here's the list:
- Glossy gloom: Folks, the annual report, with all its glossy pictures and upbeat forecasts, is usually nothing more than a song and dance. Still, it can contain some vital information. My suggestion: Read the chairman's letter to shareholders. If it suggests the company isn't doing as well as it planned, consider steering clear.
Case in point. On March 5, 2001,
Gateway (GTW) filed its 2000 annual report. And although the tone of the report was generally upbeat, there were a few warning signs in Ted Waitt's introductory letter. In fact, Waitt referred to the company's problems with prices, costs and economic change. He also hinted that cost-cutting progress could be iffy ahead.
End result: After the report was made public, the stock started dropping (from $16 and change) and never stopped. Only savvy investors who picked up on Waitt's subtle hints were able to bail before it was too late.
Future shock: Last July, when
Merck (MRK) - Get Report was trading at $63.89, I suggested the stock was
overvalued for several reasons. Sales of two of its biggest drugs, Vioxx and Zocor, had fallen short of expectations; gross margins had fallen consistently over the past five years; and its drug pipeline paled in comparison to some of its rivals.
Turns out I was on the money. Since the article appeared, the stock has come down more than 8 points, or roughly 13%. But rather than gloat, what I want to point out is that you didn't have to be a rocket scientist to figure this one out. You merely had to read the company's press releases and draw some pretty common sense conclusions as to the drugmaker's earnings potential. Again, the lesson everybody should learn from Merck is that if a company doesn't have a major revenue driver in the works and its margins are in decline, it makes sense to stay away.
Icky industry: In October, I recommended a database software company in my newsletter,
The Value Investor, called
Sybase (SY) - Get Report. And after management reaffirmed its full-year 2002 earnings outlook on two occasions, I was convinced the stock was headed higher -- that was, until one of the software industry's 800-pound gorillas,
Veritas (VRTS) - Get Report, said the industry's outlook for the second half of the year might not be as bright as some investors thought.
So I recommended selling Sybase on April 9 at $15.78. And good thing I did because the stock has since come down to $13 and change. Bottom line: Investors need to be aware that strong earnings in and of themselves don't guarantee a higher stock price. And, like it or not, that the earnings outlook for the entire industry (good or bad) will have an impact on the share price.
Cash crunching: I'm not saying that investors should ignore a company's earnings per share altogether. But in my mind, an even more important number can be found on the cash flow statement. In fact, a company's operational cash flow is probably the most important number a company will report on a quarterly basis because it shows exactly how the firm made and spent its money. Moreover, a deterioration in operational cash flow should serve as a big red flag that the stock might be ripe for a fall.
Here's a great example of what I mean. For the six months ended April 2001,
Ciena's (CIEN) - Get Report operating cash flow totaled $117.8 million. And for the nine months ended July 31, 2001, its operating cash flow totaled $95.1 million. To be clear, this number was still more than double the $41.9 million in operational cash flow the company generated in 2000. But the sequential decline should have raised a few eyebrows.
Bottom line: Had you dumped the stock immediately after the company filed its 10-Q on Aug. 16, you'd have saved yourself a bundle of money, given that the stock was trading at more than $19 at the time. Now it's in the single digits.
In short, these tips won't save you in every situation. But they will help you limit your losses and preserve your investment capital. And in this market, that's important.
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In keeping with TSC's editorial policy, Glenn Curtis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. While he cannot provide personalized investment advice or recommendations, he invites you to send comments on his column to
Curtis is also the author of the TheStreet.com's, Era of Value -- a premium subscription newsletter containing Glenn's model value portfolio, in-depth analysis, specific value stock picks and investing recommendations.
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