3 Stocks on Bubble Watch

Can you tell when a company's stock is about to implode? Few people have repeatedly and accurately predicted massive declines in the companies they follow. But the five steps I'm about to list might help improve your foresight when it comes to corporate calamities.

History serves an important lesson
Back in 2000, investors were blinded by the Internet sector's phenomenal growth. Many experts jumped on the tech bandwagon, but Wharton professor and writer Dr. Jeremy Siegel joined 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. In the ensuing fallout, giants such as Yahoo! and Oracle shed 80% or more. Siegel proved adept at identifying this dangerous trend, going 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 of large, little-known companies.
4. Avoid triple-digit price-to-earnings (P/E) ratios.
5. Never short sell in a bubble.

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

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

Look elsewhere
Instead, Siegel and other investing gurus suggest finding 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 lags expectations, and whose existence flies far below 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 to significant bottom-line appreciation.

Examine three small-cap stocks that have done just this in relatively sleepy industries:

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

Instead, you're more likely to profit from small companies in underfollowed industries that have demonstrated a real ability to make money. We follow this strategy at our Motley Fool Hidden Gems small-cap investing service, and our recommendations are beating the market's average by nearly 20 percentage points.

You can take a look at the stocks Hidden Gems is recommending today by joining the service free for 30 days. Click here for more information.

Fool analyst Nick Kapur has no material position in any company mentioned above. Affymetrix is a Rule Breakers recommendation. The Fool has a disclosure policy.