Stocks on Bubble Watch

Editor's note: A previous version of this article mistakenly included Siliconware Precision Industries in the table of high-P/E stocks. We regret the error. 

Can you tell when a company's stock is about to implode? Few people, if any, have repeatedly and accurately predicted massive declines in companies. But I have five steps that might offer you some assistance.

History serves an important lesson
Back in 2000, investors were blinded by an Internet world that was growing at a phenomenal rate. Many experts jumped on the tech bandwagon, but Wharton professor and writer Dr. Jeremy Siegel was among a small, vocal minority that failed to hear the siren song.

Siegel openly critiqued many Internet companies and their overly generous valuations, including networking giant Cisco Systems. This stock went from a high of $82 in 2000 to lows of $10.39 two years later, turning an investment of $10,000 into a pittance of just $1,267. In fact, Cisco brought Siegel fame -- and perhaps infamy -- when he discussed the company on CNN's Moneyline:

It's a super company. I would probably buy it at 80 times earnings, but at 150 times earnings? We have six stocks in the top 20 (market value) over 100. We have had no history of this. Never have stocks been worth over a hundred times earnings once they've gotten to the size of these companies.

Remember when that happened?
The rest, as they say, is history -- with other giants such as Yahoo!, Oracle, and Qualcomm (Nasdaq: QCOM) shedding 80% or more. Siegel proved adept at identifying this dangerous trend and went on to write about it in The Future for Investors. While the book offers plenty of investing gems, I believe his five simple lessons for how to avoid losing money in a bubble are the most valuable:

1. Valuations are critical.
2. Never fall in love with your stocks.
3. Beware large, little-known, or little-understood companies.
4. Avoid triple-digit price-to-earnings ratios (P/Es).
5. Never short sell in a bubble.

Three questionable calls
With an eye toward lessons three and four, here are two stocks that may have gotten ahead of themselves:

Company	Market Cap (Billions)	Trailing P/E
Broadcom (Nasdaq: BRCM)	$16.7	107
Rostelecom (NYSE: ROS)	$7.1	158

Now, these companies might just go on to defy the odds. But I suspect you'll want to be on your game in case the companies begin to miss what are very optimistic expectations.

Look elsewhere
Siegel and other investing gurus suggest that investors find companies that don't carry rich valuations, have clear-cut business models, and offer more than just simple growth opportunities. But that's not all.

In his book, Siegel suggests that investors might want to look toward industries whose growth is below expectation, and whose existence is under the average investor's radar. Why? A successful company in an underperforming industry can also be explosively profitable, because it will "maximize productivity and keep costs as low as possible" while simultaneously outliving competition. This translates into significant bottom-line appreciation.

Examine three small-cap stocks that bested the market in relatively sleepy industries:

Company	Industry	Market Cap (in Billions)	Trailing P/E	3-Year Annual Return
Smith and Wesson (Nasdaq: SWHC)	Firearms	$0.45	33	95%
WD-40 (Nasdaq: WDFC)	Household products	$0.64	21	14%
Cleco (NYSE: CNL)	Electric utility	$1.59	10	16%

Forget the hype
Chasing hot companies in hot industries will often leave you burned. In the long run, it's likely that a company's valuation will land squarely alongside its earnings capacity -- which is often unproven when a company sports a triple-digit P/E.

Instead, you'll be rewarded by buying shares of small companies in underfollowed industries that have demonstrated a real ability to make money. We follow this strategy in our Motley Fool Hidden Gems small-cap investing service, and our recommendations are beating the market average by more than 31 percentage points. In fact, Hidden Gems was the best-performing investment newsletter of the past 12 months, according to the independent Hulbert Financial Digest.

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This article was originally published July 10, 2007. It has been updated.

Fool analyst Nick Kapur owns no shares of any company mentioned above. Yahoo! is a Stock Advisor recommendation. The Fool's disclosure policy keeps a level head.