Be Afraid of These Stocks. Be Very Afraid.

Riddle me this, savvy investor: When is good news actually bad news?

By way of an answer, consider United Parcel Service (NYSE: UPS  ) , Akamai (Nasdaq: AKAM  ) , and CarMax (NYSE: KMX  ) . Each of these companies has a higher forward price-to-earnings ratio (P/E) than the S&P 500. However, over the past 12 months, they've also lagged the S&P in stock-price performance. The same is true of Toll Brothers (NYSE: TOL  ) , Wendy's International (NYSE: WEN  ) , and E*Trade Financial (Nasdaq: ETFC  ) .

So what's the problem? Call it the "rosy scenario" syndrome: Analysts expect double-digit earnings growth for each of those stocks over the next five years.

Isn't that good news?
In the abstract -- and if the analysts turn out to be right -- that's good news indeed. But the market is especially efficient when it comes to pricing in (or discounting for) growth stories. When macroeconomic data or industry-specific news comes along and shakes up the sunny growth story, highfliers like these will drop in a hurry.

I'm not saying you shouldn't own these stocks. Companies with high growth prospects are nothing to sneeze at, particularly if you have a stomach for volatility. But even if you consider yourself an investing genius, world-class mutual funds can offer you a smarter way to snag the market's pricier prospects. You'll get the market-beating potential of growth stocks, along with a smartly constructed portfolio that should help tame wild performance swings.

Two for the price of one
But not just any fund will do. As part of the Fool's fund research team, I'm constantly on the lookout for:

1. Strategic tenacity: Growth investing has been in the doldrums since the market melted down in early 2000. In this climate, we're especially interested in growth funds led by managers who have stuck to their guns during this downturn, snapping up the companies they like at substantial discounts to their earnings-growth potential. After all, when their area of the market falls out of favor, otherwise rock-solid companies can offer managers high-quality investments at discounted prices.

2. Healthy skepticism: Managers who fall in love with a stock's "story" don't make the cut. When it comes to growth investing in particular, it's too easy to become overly wowed and fall prey to "irrational exuberance." (See the late 1990s for the gory details.) With that in mind, we want growth managers to be as unemotional about their work as possible, and to have defined sell criteria. Yes, we should all be inclined to let our winners run -- but we shouldn't let them run away.

3. Intelligently placed bets: Risk is baked into growth investing, and because we want to beat the market and get a good night's sleep, we favor managers who run intelligently diversified portfolios. We're not averse to funds that pack considerable sums into individual names or certain areas of the market. But at the same time, you likely won't find us recommending, say, a tech-sector fund, either. There are smarter ways to get the growth job done.

Speaking of which ...
If you'd like to invest fearlessly in the market's "scariest" stocks, consider taking the Fool's Champion Funds service for a risk-free spin. Our overall list of recommendations is spanking the market as I type this. And yes, we do have a selection of terrific growth funds -- hand-picked go-getters that have what it takes to get the market-beating job done.

Click here to give Champion Funds a test-drive, and find out more about why top-notch mutual funds make the ideal safeguard for your money.

This is adapted from a Shannon Zimmerman article, originally published Jan. 16, 2007. It has been updated.

Fool analyst Adam J. Wiederman thinks of himself as a daredevil with brains. He owns no shares of the companies mentioned above. Akamai is a Rule Breakers recommendation. CarMax is an Inside Value choice. UPS is an Income Investor selection. You can check out the Fool's strict disclosure policy by clicking right here.


Read/Post Comments (3) | Recommend This Article (2)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 18, 2008, at 6:38 PM, methusalaw wrote:

    Mr. Wiedemann:

    It is extremely unfortunate that you like some of the other lazy analysts have not even looked at E*Trade's health and value since November of 2007 or you wouldn’t have made the comment you did concerning them. If you had, you would see that E*Trade is currently trading at an extreme discount to its value and based upon the recent sell of its Canada Operations can be expected to have a reasonable PPS value of $15 whereas it is currently trading at <$4.00 due to massive short pressure of 23-27% of available float. E-Canada was sold for $420M ($511M after repatriation of funds) for 125,000 client accounts or <3% of Q1 total client accounts (increasing at rate of 1000/day). Even on the most conservative extrapolation of the worth of the rest of the company we have ($511M/.03 = $17B) approximately $34/share value. If we even value the rest of the company at 1/5 we have $3.4B or $7/share value. If you would have looked at E*Trades recovery Plan, current balance sheet, reserves against a better than expect performing mortgage portfolio, on and on and on....you would realize that they very well may be reporting a positive earnings on 7/22/08 vs. expected loss of -.13 to -.16. This means E*Trade would have positive fully 2Qtrs ahead of their aggressive plan and a full year ahead of analysts’ projection; surely this would command rise in PPS to well over $6.00 and a dramatic short squeeze pushing the stock’s PPS even higher. There is much more to support double digit PPS by 1QTR 09, but there is insufficient space here to include. Bottom line, get off your brain and do some DD before lumping E*Trade with failing companies just to get ratings.

  • Report this Comment On July 20, 2008, at 7:51 PM, sdansker wrote:

    methusalaw: I couldn't agree more. By this time next year ETFC will be well into the teens, unless more dimwitted analysts like Weiderman keep trashing the stock with less than logical "analysis".

  • Report this Comment On July 24, 2008, at 3:19 PM, TMFDonauschwaben wrote:

    First of all, please do me the dignity of spelling my name correctly if you wish to rebut facts in my article.

    Secondly, I did not specifically bash ETFC, or any of the stocks aforementioned, though I could see how you might reach that conclusion. Ultimately, all I did was point out the obvious facts that they have "a higher forward price-to-earnings ratio (P/E) than the S&P 500 [and] over the past 12 months, they've also lagged the S&P in stock-price performance."

    Had you read the article, you also would have noticed the fact that I specifically stated "I'm not saying you shouldn't own these stocks," but that mutual funds are a great way to get these high-growth stocks because they offer the benefits of "a smartly constructed portfolio that should help tame wild performance swings."

    Next time, please read the article in its entirety before bashing me with name-calling.

    Thanks,

    Adam J. Wiederman

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