If you're like me, you spend most of your stock-sifting time searching for hidden gems or other similar growth investments. After all, we're usually looking for the next big winner in the stock market, right? I mean, who wouldn't want the 75% average returns that Tom Gardner's Hidden Gems newsletter has achieved in the last seven months of stock picking?
We buy stocks we think are going to go up. Sometimes, however, it pays to look at the flip side and seek out businesses that might be on shaky ground. Today, we'll look briefly at three companies whose stocks have been on fire lately. But are they about to crash and burn?
As I mentioned in my column last week, I enjoy using various stock screens as a way to generate new ideas and expose myself to new companies. I use both fundamental analysis and technical analysis screens to find ideas. This week, I'll introduce you to a very simple technical screen I use to ferret out stocks that have risen abnormally fast.
200-Day Moving Average
Most people who analyze price movements in stocks will employ moving averages in their work. A stock's moving average is simply the average of the closing prices for the stock in the last "x" number of days, plotted over time.
Perhaps the most oft-used is the 200-day moving average. Technicians will tell you that stocks trading above this average are doing OK, while stocks that trade below it are having a rough time. Indeed, many people will use that 200-day moving average as an inflection point, buying when a stock breaks through it to the upside and selling when a stock falls under it on the downside.
The logic beyond the voodoo is that if a company is doing reasonably well and growing its business, the price of the stock should reflect that growth and the stock should rise steadily over time. If a stock is rising steadily, the current price should always be somewhat higher than the 200-day moving average. Conversely, if investors lose confidence in a company's ability to grow, they might sell the stock, causing it to drop below the 200-day moving average. Technicians consider this a bad sign and a "sell signal."
Irrespective of whether you buy into this or not (and the Fool generally eschews technical analysis), the 200-day moving average can be a useful tool to identify investor sentiment, in the extreme. For my technical screen, I look at companies whose stock price today is four times the 200-day moving average. In other words, something has happened in the recent past that has driven the stock up very fast, causing it to trade significantly higher than its 200-day moving average.
From looking at this screen over time, it is abnormal for a stock to trade at such a multiple. In my experience, after watching this screen for more than five years now, one of two things generally happens. The stock either drops pretty hard, bringing it back to earth, or the stock price stays about the same for a fairly long time, almost as if it were waiting for the moving average to catch up. Of course, this simply means that investors are less willing to buy at these lofty heights, or perhaps even wanting to take some profits off the table.
What almost never happens is that the stocks continue to race higher. Even in the bubble run of the late 1990s, it was rare to see a stock exceed four times its 200-day moving average.
Out of almost 7,000 companies in the database I use for this screen, only nine stocks currently trade at more than four times their 200-day moving average. Four of these trade below $5, and are considered penny stocks. I'm not a big fan of looking at the pennies, so I generally disregard these companies. That leaves us with five:
ChipMOS Technologies (Bermuda)
The intriguing thing about this particular stock screen is that each of these companies has risen very far, very fast, but we don't know why yet. Part of the fun of this kind of investigating is that after finding these stocks, it's now time to turn toward the fundamentals to try to understand if something truly special is happening to explain the incredible rise in the prices, or if investors are simply building castles in the air. In some cases, with special companies, you identify a potential future investment. In other cases, you identify a stock you might be willing to short.
After a cursory look at each company, here's my quick take on each one:
Taser International -- As fellow Fool Seth Jayson pointed out Friday, Taser has seen a dramatic rise in both revenue and net income, along with solid increases in profit margins. The company has new inroads at the Pentagon and has strong ties to the law-enforcement community. It seems like there is some fundamental justification for the incredible rise in its share price. Even if I thought the stock was too richly priced, I wouldn't short it, largely because good things are happening at Taser.
Nanogen Inc. -- Nanotechnology is the hot buzzword in many technology circles and a number of small public companies (Altair Nanotechnologies
(NASDAQ:ALTI)and Nanophase Technologies (NASDAQ:NANX)among them) are benefiting from all the attention. The big news for Nanogen is the patent it received on Nov. 25 that lets it play in the subatomic sandbox. The problem with shorting nanotechnology is that there are going to be a few massive winners along with the many losers and hype jobs. Right now, I'm not smart enough to differentiate. My inclination isn't to short this group, but rather to buy very small dollar amounts in a handful of them, knowing that most will fail, but one or two will be absolute home runs.
ChipMOS Technologies (Bermuda) -- I know this isn't fair, but don't you get a little freaked out by the fact that it has "Bermuda" in the name? Kidding aside, this is a Taiwanese company incorporated in Bermuda. It does semiconductor testing and controller assembly. ChipMOS has also been working closely in the LCD market, which is red hot right now. With more than 1,700 employees and profitable, it may be expensive, but I wouldn't be shorting it.
Intelligroup -- These folks are IT consultants and for the life of me I can't understand how the business is worth $150 million when it can't make any money. This stock was $1 in July and now it's close to $10. The company showed a very small profit in the most recent quarter, which is probably what's making people so excited, despite a sea of red ink prior. The only other thing to consider is that it pulled in more than $100 million in revenue. Perhaps the market believes Intelligroup's customer base would be valuable to some other competitor. Still, I'm a bit suspect of this one and will likely dig in much deeper.
- Arrhythmia Research Technologies -- This is the one that concerns me. The company traded at $3 in early 2003 and now trades at over $30. It has slightly declining revenue and is slightly profitable. It makes products designed to detect deadly heart arrhythmias. The odd thing is that there hasn't been a significant piece of company news in over a year. No great new contracts to boast about, no nothing -- yet the stock is up over 1,000%? That makes absolutely no sense and is something I intend to look into in much greater detail. Of the five companies on the screen, this feels like a hype job and is my one solid short possibility. I'll be digging around and try and provide an update next week.
As you can see, a simple technical stock screen like the 200-day moving average unveils a number of interesting companies, for both the short and long sides. Sometimes the key to successful investing is in looking to the extremes and asking yourself, "How long can this possibly continue?"
David Forrest does not own any of the companies discussed in this article. To see the stocks David does own, check out his member profile .