Monday, January 31, 2011
Earnings season reminds me of watching a car race. There's always bound to be a crash.
This season's crash happened earlier this month when F5 Networks (FFIV) plummeted 21% after reporting earnings. Growth Stock Wire readers knew this was coming. But many F5 investors were stunned. F5's numbers weren't "bad." The company beat earnings expectations by a solid margin.
In 10 years of research, I've seen this setup too many times to count. F5 is a solid growth company that makes software used in cloud computing – a huge growth trend I wrote about last summer. Yet shares took a dive on solid results.
The problem was that investors had been buying F5's stock hand-over-fist for over a year. Before taking a dive, shares had almost tripled over the past year. When a stock goes up in a straight line month after month, investors' expectations often increase right along with the share price. These building expectations leave less room for even the slightest disappointment.
In F5's case, a "good quarter" wasn't good enough.
There's a super-simple way for small-cap traders to sidestep the kind of crash F5 shareholders suffered. And if you keep an eye on this one number, you can multiply your long-term results six times over... Before I get to the details, though, take a look at this chart:
The Russell 2000 is the most-recognized index for small-cap stocks. Russell divides this index into two separate categories: growth (the red line above) and value (the blue line).
Price-to-book is one of the main factors used to determine which stocks go into which index. Stocks with a lower price-to-book ratio go into the value index. Since late 2000, the cheaper stocks – the stocks with lower price-to-book numbers – have returned six times as much as their more expensive peers.
A company's book value is a simple way of totaling its assets minus its liabilities to find intrinsic value. You might pay five times book value for a World Dominating company like Coca-Cola. That company is worth much more than the value of its factories.
But even after falling more than 20% off its highs, F5 is still trading above eight times book value. Other high-flying stocks like Netflix (NFLX), Salesforce (CRM), and VMWare (VMW) all trade at 10 times book value or higher.
The fact that a stock is expensive doesn't mean it's destined to crash. After all, Netflix was expensive when it traded at 25 times book value last year. Now it's at 50.
But like I said, a high valuation means high expectations. These companies are priced to perfection. Anything short of that could mean an F5-like crash.
For more safety and better long-term results in your small-cap portfolio, stick with the value names.
"Cloud computing might sound like the latest fad for geeky analysts to jabber about at conferences... But over the long term, it's one of the safest, biggest bets in tech." Read more here: A Huge Buy Signal from the Biggest Tech Trend in Years.
Last week, Larsen recommended the safest tech stock to buy today. The more devices connect to the Internet, the more dominant this company becomes. Get the details here: You're Ignoring the Best Bargain in Tech's Hottest Sector.
ConocoPhillips and Suncor surge to new highs... crude oil prices jumped 4% on Friday.
The S&P 500 trades lower for second week in a row... a move we haven't seen since August.
Ag giant Potash soars more than 20% in a month.
Fear index VIX rocketed more than 20% on Friday... its biggest one-day move in over six months.