Back in January, I wrote a column called Stocks at the Extremes in which I discussed several stocks that were trading three or four times their 200-day price moving average. My premise was that any time a stock moves so far, so fast, something unique and abnormal is going on. Either the company is doing something really special and the world has just woken up to it, as was the case with Taser International (NASDAQ:TASR), or investors are getting carried away. Nine times out of 10, it's the latter.
One of the companies on the list in mid-January was Arrhythmia Research Technology (AMEX:HRT). At the time, I wrote, "Of the five companies on the screen, this feels like a hype job and is my one solid short possibility." The stock was $34 that day and climbing. At one point in February, Arrhythmia Research traded as high as $48. Boy, did I feel stupid. Today, however, the stock sits just north of $24, exactly half of what it was worth less than 30 days ago. Sorry, friends, the stock didn't split. I mean, it did, but not in that warm, fuzzy way. The stock market gods giveth, and they apparently taketh away just as easily. So, what's going on here?
Putting a hurt on HRT
As I mentioned earlier, I thought this was probably going to be some hype job with Internet touts pushing up a thinly traded issue to the moon and right into a giant game of stock market musical chairs. Who'd be the last to react to the stopped music? I sure do feel bad for the poor soul who did that trade at $48.15. Talk about whiplash! Oddly, however, the notes I received after my column weren't from people angry at me for slamming their favorite hype-job stock, but applauding me for calling it out.
What? How can this be? I thought there was some Internet hype machine behind all of this craziness. But, straight out of the truth-is-stranger-than-fiction files, I learned that the primary driver of the stock price was the inclusion of Arrhythmia Research in IBD's Top 100. For those who don't know, Investor's Business Daily is a fine newspaper (take a two-week trial free!) that helps people rank stocks based on certain fundamental and technical criteria. Each week they publish the list of the top 100 companies that meet their statistical criteria for CANSLIM investments.
One of the major components of the IBD Top 100 is relative strength. As we discussed in High-Octane Investing, and as we all know from our physics lessons in high school, an object in motion tends to stay in motion until acted upon by some force. In the world of momentum investing and relative strength, this simply means that stocks that are going up will inevitably attract the attention of lemmings... uhm... investors that want to hop on the bandwagon. Naturally, this begets more strength in the stock price and relative strength rankings.
The downside of all this fun is that momentum investors will bail out on a stock at the first whiff of a slowing stock price, i.e., decreasing momentum. Combine a rocky stock market of late with an earnings report from the company that didn't exactly blow the doors off the joint, and you have a recipe for a quick 50% haircut.
The pulse on Arrhythmia
What about poor Arrhythmia Research Technology? What about the actual underlying business? Now that the stock has been cut in half, is this a bargain? To be fair, I don't think the company is anything more than a victim of its own popularity. Naturally, when we see such meteoric rising and falling, we wonder about the company and if anything shaky is going on. While I obviously can't say for sure, I really don't think there's anything amiss. From my standpoint, Arrhythmia Research is a relatively unexciting business that sells silver-plated sensors used in a number of medical monitoring devices, most notably, ECG machines.
While I don't want to diminish the important work the company does to bring these sensors to market, it's not exactly rocket science, and it's not exactly growing like gangbusters. The company has compounded revenue at an annual clip of just 3.7% since 2000. Even though it's an unexciting business, it is a profitable one with just under $0.50 in trailing earnings per share. With almost no growth in the top line and a steady but also stagnant bottom line, it's incredible to me that investors would bid this up to over 100 times earnings less than a month ago. It's still crazy to give this a P/E of 54.
There is no growth story here that's discernible from anything the company has to say. Indeed, the company recently issued a dividend that represents 10% of total net income for all of 2003. Without coming out and explicitly saying so, the company is admitting that they don't have a better use for the money than to return it to shareholders. Don't get me wrong, we're all in favor of this kind of decision when the capital is best allocated by the investor. But it speaks volumes about the growth potential of this business. I just can't see any exciting reason to invest in Arrhythmia Research, even at $25 a share.
Current stocks at the extremes
Now that we've revisited Arrhythmia Research Technology, you might be asking yourself what companies are currently trading well in excess of their 200-day price moving average? There are two that I can tell you about:
1. Industrial Services of America (NASDAQ:IDSA). The stock traded at $4.20 on Feb. 5, at $47.50 on March 1, and at $27.50 today. Industrial Services of America is a waste management and recycling services company. Why do I get the impression Tony, Silvio, and Paulie Walnuts have something to do with this?
2. Danielson Holding Corp. (AMEX:DHC). As the name says, this is a holding company with several "indirect subsidiaries" focused on marine transportation and insurance products. Nice combo. The company is not profitable and has declining revenue.
Are these the new "stocks at the extremes?" Only time will tell. The major lesson to gather from all of this is that for a stock to rage like some of these stocks have raged, there better be an exciting business underneath to justify the price. The implication for you, dear investor, is to understand what these companies do before you buy stock in them. Yes, I'm talking to you.
Now what?
While these "extreme stocks" may not be very exciting small-cap businesses, you can take a free trial of Motley Fool Hidden Gems and learn about strongly growing small-cap businesses that give you good, fundamental reasons to be excited. Take the trial and find out about my favorite stock idea of late.
David Forrest doesn't own any of the stocks mentioned in this article. On the off chance that IDSA is a "family" business, he would like to say that he appreciates the sanitation engineers in his town. The Motley Fool is investors writing for investors.
