Love Your Losers

Back in 2003, we opened one of the first issues of our newsletter with this warning:

Suppose I told you that over the next 18 months one of our Motley Fool Hidden Gems recommendations would drastically disappoint. Its asset base would crumble, management would resign in disgrace, and the stock would plunge a full 50%. Yet, I couldn't tell you which one.

Well, it turns out that we were wrong -- we haven't had one drastically disappointing recommendation. Our team of analysts has had four, three of which are now sold off our scorecard. They are:

  • CardioDynamics (Nasdaq: CDIC  ) : down 46%
  • eSpeed (Nasdaq: ESPD  ) : down 56%
  • QLT (Nasdaq: QLTI  ) : down 55%
  • FlamelTechnologies: down 28%

Of those companies, only Flamel remains an active recommendation -- and that's because renowned money manager Oscar Schafer forced a CEO change through his shareholder activism. Even with those substantial losses weighing us down, our newsletter is ahead of the market by nearly 20 percentage points in our more than two years of existence. First, that is a tribute to the power of broad diversification when investing in promising (yet unpredictable) small-cap stocks. Second, it indicates that we constantly learn from our mistakes as we work to help subscribers invest successfully for the long term.

We recently received an email from a reader asking us to make our list of losers public. We are happy to do so -- and, in so doing, we hope to offer some takeaways about what made them losers in the first place and what investors can do to avoid such stocks in the future.

Learn from losing valuations
When CardioDynamics was recommended by analyst David Forrest, it seemed to have a bright future. The $200 million company was already profitable and cash-flow positive, and its BioZ cardiography monitoring systems were being adopted to diagnose heart disease.

But the stock was priced to perfection. In order to find a compelling valuation, we had to predict 40% to 50% five-year revenue growth when even the CEO was only predicting 30%. Although higher numbers were possible given the enormous market share left for BioZ, they were quite optimistic. During the two years that CDIC was an active recommendation, the company repeatedly lowered guidance and blamed an inexperienced sales force for revenue growth that came in at 29%, 25%, and (in the past 12 months) an anemic 3%, respectively. Over that time the stock was cut in half, and we cut our losses by selling.

The lesson: A crucial aspect of investing is playing defense. If you're using optimistic models, most investments will look great on paper. The key is to find companies that have the power (and valuation) to prosper in both good times and bad. Think of emerging category kings such as Dell (Nasdaq: DELL  ) and Gap (NYSE: GPS  ) back in 1995.

eSpeed suffered from similar problems. The company was essentially fairly valued by the market, and (Tom here) my brother David's growth hypothesis involved eSpeed's technology grabbing more and more of the $11 trillion transaction market ... which didn't happen. eSpeed's technology didn't offer any advantages over competing platforms, and the death knell came when a court ruled that its patent was invalid. Only in an overly optimistic scenario would eSpeed have been a long-term winner of the 15% to 20% annualized variety that we seek in Hidden Gems.

The lesson: Technology products without moats and strongly loyal customers will quickly be lapped. A recent example and quick test of this is Google (Nasdaq: GOOG  ) -- Google's very name is synonymous for "a fast and comprehensive search of the Internet." We're also very confident in the positive customer feedback and high renewal rates at recent Hidden Gems recommendation Blackboard.

Learn from losing hypotheses
One of biotech analyst Charly Travers' key investment theses for QLT was that its Visudyne product for age-related macular degeneration (AMD) would keep revenues rising until the company was able to get new products -- Aczone and Eligard -- on the market. Unfortunately, Aczone and Eligard did not pick up the slack when Visudyne lost market share to Eyetech's recently approved Macugen drug. That chain of events quickly turned QLT from a growth story into a stagnant, fully valued company -- not what we're looking for in Hidden Gems.

The lesson: Pharmaceuticals can be a difficult and unpredictable place to invest. Although we missed with QLT, Charly helped us triple our money on the now-acquired Transkaryotic Therapies. Sometimes, no matter how conservative your assumptions, the market just doesn't break your way. So diversify.

Learn from losing CEOs
Flamel Technologies is an emerging nanotechnology company whose drug delivery systems help major drug developers find more efficient ways to administer their products. The stock has been a loser for us since I originally recommended it in the June 2004 issue. Although the company boasts a sterling balance sheet and promising technology, we substantially overestimated the shareholder friendliness of former CEO Dr. Gerard Soula.

When a partnership with Bristol-Myers Squibb (NYSE: BMY  ) broke down, it became clear that management was not building strong relationships with customers and not being forthright with shareholders. Moreover, Dr. Soula -- who cashed out $10 million worth of shares at $31 -- received a batch of options priced at $2 per stub. Overcompensated management was overpromising and underdelivering. That's a recipe for disaster -- and Flamel stock dropped all the way down to $13.

Then, Soula was ousted and replaced by CFO Stephen Willard, who immediately honored our request for an interview (a request Soula had refused). Willard seemed to know what needed to be done to build a stronger business, and we re-recommended the stock. Although Flamel has yet to become a winner for us, I am more confident than ever before that it has strong future prospects now that shareholder-friendly management is in place.

The lesson: Bad management can sink a company with even the most superior product, financials, or business model.

Foolish final thoughts
At Hidden Gems, we recommend that subscribers open positions liberally, gain a bit of mastery from each, and learn why certain investments do or do not work -- without ever imagining that we've learned every lesson. One of the most important lessons we've learned as a team is the importance of superior CEOs -- a lesson we intend to practice with every future recommendation.

Through our system of broad diversification and constant learning, we've picked winning stocks more than 60% of the time, and on average, our picks are 20 percentage points ahead of the market. If you'd like to try out our service, see what we've learned, and benefit from our research, click here to take a 30-day free trial. There is no obligation to subscribe, and we'd be honored to have you join us. We look forward to many years of market-beating returns for our thousands of subscribers.

Fool on!

Fool co-founder Tom Gardner is the lead analyst of Motley Fool Hidden Gems. Tim Hanson sits near Tom Gardner and listens to him opine. Neither owns shares of any company mentioned in this article. Dell and Gap are Motley Fool Stock Advisor recommendations. The Motley Fool has adisclosure policy.


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