The Bad Stock and the Ugly Stock

 

Bad Stock

Ugly Stock

… And How to Identify Them

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In my last column here in September, I wrote about a good stock, AuthenTec (AUTH).

In a nutshell, a good stock is a company with a better mousetrap, tsunami-like trends for products the company makes or services the company offers, the law of large numbers, validated market position and validated products by the industry’s movers and shakers.

AuthenTec was a home-run recommendation, quickly acquired by Apple at a high premium. (If you missed it or would like to brush up, you can view it here.

Today, instead of good stocks, I look at the bad and the ugly.

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Bad Stock

A bad stock starts out in good health, but without any prior notice, it falls on hard times. There really isn't a reliable set of rules other than technical analysis and gut feeling to signal that illness has set into your stock.

But there are some potential signals:

On the stock’s chart, you many notice a sharp price drop with accompanying high volume, a long established positive trend line that abruptly gets broken or a trendline that points down without reprieve.

There are also other cues that can indicate impending troubled waters, such as when the company puts out a great news release but the stock doesn't respond by moving up in price. Sometimes, the bright news even triggers a decline in the stock price.

Ugly Stock

As for an ugly stock, there are some telltale signs. If you see any of these indicators, you may want to pass on buying the stock, or if you already own it, sell it quickly.

• The CEO paints an infinite blue sky for the company and never mentions clouds. Surely, there are challenges in business and maybe even competitors.

• The CEO's financial projections challenge your beliefs. Lofty markets with instant profits should never make perfect sense.

• Is the CEO motivated to run the company after he's become a billionaire? Check his salary against the financial performance of the company.

• The CEO says he’s got the latest and greatest product, but he's been saying that for years and the product hasn't generated any money.

• The CEO insists he's running a growth company but it’s more like a research lab. Check to see if R&D efforts are resulting in higher sales growth. A company that spends too much time in R&D isn't in the businesses of making money.

• The CEO says he will be instrumental in bringing a product to market, but never in his career has he pulled it off. Make sure you check his ID at the door; a CEO without a track record of success won't usually make dough rise.

• The CEO promised he'd have a product to market by a certain start date, but missed it. The timing of product introductions is important because a product that comes to the market late can often be obsolete by the time it reaches the marketplace—and customers will go elsewhere to have their needs met.

• The CEO says he'll grow the company through acquisitions, but a lack of acquisition candidates can spoil growth plans. If you must decide, always choose organic over acquisition-related growth.

• The CEO says he's invested in the company right alongside you. If investing alongside you means stock options versus stock ownership, it’s time to look for another company in which to invest. (Another note: well-run companies don’t re-price options to make up for unattained goals.)

One last tip to help you focus on good stocks rather than bad or ugly: Go for the touch and feel versus investing in something that's not commercially proven yet. Neither concepts nor thin air will ever make you any money.

Your guide to small-cap investing,

Thomas Garrity,

Editor of Small-Cap Confidential

P.S. Performance of Cabot Small-Cap Confidential since January 2009 was 32% per stock!

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