Look for clues that a stock is primed for a blowup


We rarely get to the closing bell these days without some stock experiencing a huge single-day decline. With seemingly random drops of 20 percent or more becoming routine, practically any portfolio can be hit hard.

Some even endure a 50 percent one-day haircut. My first such blowup dates to Feb. 10, 1992, and involves the first stock I'd ever doubled my money on, MGI Pharma. I'm still trying to block out the memory, but the conversation with my broker went something like this:

Me: "How'd MOGN close?"

Broker: "Whoa! $10.75, down 11.63."

Me: "I didn't hear about the stock split!"

If only!

The problem is that stocks tend to go up slowly and down fast. Consider a stock that gets cut by half or more - for example, the recent debacle of HealthSouth Corp. (down 58 percent on July 27-28). The decline can take nanoseconds; most of the damage is usually done by its first trade. But getting back to even means the stock has to double in value. It might now be attractively priced, but even if HealthSouth returns a respectable 10 percent annually from its July 28 close, getting back to its cost on July 26 would take nine years.

So, is one of your stocks about to blow up? It's impossible to know for sure. If people knew a stock was about to plunge, they'd be selling it now. Certain conditions, however, make a stock more prone to blowups than others:

Previous blowups. As far as I'm concerned, this is the No. 1 sign that a stock will soon be in trouble again. Call it the cockroach theory of investment: When one shows up in the kitchen, no matter how lonely it seems, more are almost certainly behind the refrigerator and under the sink. One of the reasons stocks tend to react so violently to a single quarterly disappointment is that it often precedes additional problems.

Following this policy could have kept you away from what I figure is the best example of the cockroach theory, Lucent Technologies Inc. Its first profit warning took the stock down 22 percent Jan. 6, 2000, but at that point it was still $58 between that day's close and zero. Half a dozen or so blowups (one- or two-day drops of 20 percent or more) later, that $58 share would get you a dollar and change.

Lots of debt. Six Flags Inc., operator of amusement parks, was down 57 percent in one day on Aug. 13. Can a 2.5 percent drop in sales lead to that large a drop in value? It can. When there's a lot of debt (in Six Flags' case, two times equity), a wag in the company's enterprise value (the dog) can send the common stock (the tail) into a tailspin.

High expectations. This is usually reflected by a lofty valuation. A stock trading at 30 times current earnings or more (assuming the company has earnings) is betting on cash flows in the distant future to justify the current price. Moderate the company's growth prospects and the value of those distant cash flows can shrink in a hurry (VeriSign Inc., April 26, down 46 percent).

Event risk. If there's some specific problem out there - for example, a dispute with the government (HealthSouth) or a whiff of asbestos (Sealed Air Corp., July 30, down 42 percent) - the worst possibility is almost never priced into the stock. An old saw on Wall Street goes: "Never bet on a lawsuit." We'd all do well to heed that advice.

Last man standing. If every other stock in the sector has blown up, but yours is still standing, it's worth thinking long and hard about whether it can continue to sail on through. Even the biggest and strongest companies in an industry (Sprint PCS Group, Feb. 5, down 20 percent and June 14, down 27 percent) find it tough to fight trends.

Diminishing management credibility. As Enron Corp. was blowing itself up on the road to zero (including Nov. 28, 2001, down 85 percent), each utterance by its executives became less and less trustworthy. At the end of the day, senior management stands between the state of a business and the public, and if investors can't trust it, the business cannot be valued.

Just because a stock meets one or more of these criteria doesn't make it an automatic sell. After all, the premise of value investing involves a willingness to buy, as has been said, "when there's blood in the streets." But today's bargain could easily become tomorrow's falling knife, so make sure you're giving yourself a wider-than-usual margin of safety.

Then again, sometimes even the most secure-looking company (e.g. Nicor Inc., one of my hometown utilities, down 41 percent on July 19) can shock the market with an accounting flaw, lawsuit or some other catastrophe out of the blue. Now what should you do?

Mentally mark your cost to market. If you paid $4,500 for 100 shares of Tyco a year ago, don't think in terms of preserving your $4,500. Face it: It's gone. The $1,800 your shares are worth now is what is at stake. It's hard to do this - nobody likes to admit a losing decision - but it can set the stage for a colder, more rational look at the situation.

Consider the market's reaction. Sometimes a 50 percent plunge is warranted; more than a few stocks are still blowing off excess valuations these days. Then again, with market sentiment as unremittingly negative as it has been, more than a few babies will be thrown out with the bath water.

Ask yourself whether you'd be a buyer now. If you had $1,800 in cash, would you consider investing it in Tyco? Or are there better opportunities around? If there are, and you're already unnerved by the demonstrated volatility in Tyco, it might make sense to take the tax loss and move on.

If you trade in individual stocks, sooner or later one will get mercilessly crushed. Taking on this kind of risk is one of the reasons owning stocks over the long run will be more rewarding than less-risky asset classes. But the best way to minimize your blowup risk is to spread your bets. A 50 percent loss in one holding will be a lot less painful if you own many different stocks.

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