A few days back, while skimming the 52-week low list, I happened to notice a name there that I hadn't followed for a while: Coldwater Creek (NASDAQ:CWTR), a fashion retailer in competition with Ann Taylor (NYSE:ANN), Gap (NYSE:GPS), Chico's FAS (NYSE:CHS), Talbots (NYSE:TLB), and others.

When I had last checked in with the company, it was doing many things right, but sported a valuation that couldn't be described accurately by the usual cliches. "Nosebleed" didn't do it. Not even "insane." Maybe "typical Wall Street darling."

Being a complete Fool, I called up the numbers to take a look, and it was immediately clear to me that Coldwater's stock was doomed to drown. Sure, easy to say in retrospect, you're thinking, and that's a fair point. But hey, I've been buying plenty of stocks during the latest market swoon, including good, struggling retailers. Coldwater didn't even make my maybe list, and I'll explain why.

Eventually.

But first, a brief diversion into what other people may have been thinking.

Way wrong ...
Let's start with a real outlier: How about this laughably bad analysis, only two weeks old, from some shop called C.L. King. We got the usual "strong buy," and this bit of detail: "Analyst Mark Montagna said Coldwater Creek benefitted from several factors in the second quarter, including an expected inventory decline, continued selling of merchandise at full price, and fewer markdowns."

Look at that for a second, and you'll see how insane it is to base a "stong buy" decision on that set of guesses. Even if there were a 1-in-3 chance that each of those guesses was correct, there would be only a 1-in-27 chance that all three of them were correct. And, of course, it's impossible to say whether or not any of this would (if true) power Coldwater's revenues and earnings past what the rest of the Street's analysts expected. (Oh, and by the way, Coldwater missed those predictions by a long, long way. Big drop in profits, same-store sales off, the whole nine yards of crummy cloth.)

... and for the wrong reasons
I'm not picking on Montagna's call simply because it was wrong. Hey, we're all wrong sometimes. I'm picking on it to illustrate why it's wrong, and to help my fellow Fools avoid making the same mistake when evaluating stocks, especially retailers.

We are all Homers
It all has to do with calculating probabilities. Books like Fooled by Randomness and Stumbling on Happiness have covered the disconnect between the way our brain computes probabilities in the face of vivid storytelling. Here's a telling old saw: experiments show that people are more likely to show interest in an insurance policy that pays out in the case of death due to a terrorist blowing up their flight, rather than a policy that pays out in the event of any crash at all. The odds of either occurring are astronomical. Together, much much worse.

So why do people think this way? I'll let the researchers sort it out. The reality that we need to cope with is this: Our brains respond to plausible detail, even when, probability-wise, they make no sense. For some reason, we're all like Homer Simpson, who once explained his dingbat behavior with the line "I like stories."

The solution
The way to avoid falling into this trap is simple. Assume you're wrong, and calculate the odds. Step one is to scrap 90% of that junk you hear about "buying what you know." To far too many people, this turns into: "buy what I like," or "buy what excites me," or even just "buy what I saw at the mall the other day."

I'll be blunt: Your observations of what goes on at a store aren't likely to tell you anything about the health or investability of a company. Don't take it personally. My observations are worth the same (little). It's fine to channel your observations into further research, but remember that the empty store doesn't mean a bad stock, and the one with lines out the door (cough, Krispy Kreme (NYSE:KKD), cough) may be a disaster waiting to happen.

Know more than the view from the mall
Here's the "what you know" that you should buy: the numbers. And anyone who looked at the trends at Coldwater could have seen where the odds were stacking up. Let's start with revenues versus profits. While Coldwater has been selling up a storm, its free cash flow has dropped off. This isn't unusual for a retailer in expansion mode, but what is more worrisome is that growth in operating profits and cash from operations have been lagging revenue growth recently.

(Figures in millions.)

FY Ended 1/29/2005

FY Ended 1/28/2006

FY Ended 2/3/2007

LTM* 5/7/2007

Revenues

 $590.3

 $779.7

 $1,054.6

 $1,120.6

Operating Income

 $47.8

 $65.7

 $83.9

 $84.1

Cash from Ops

 $65.1

 $103.3

 $110.6

 $122.6

FCF

 $18.2

 $22.5

 $4.4

 $9.5

* Last 12 months.
Data from Capital IQ, a divison of Standard & Poor's.

Knowing that, it's easy to see that margins have been contracting in the face of higher revenues, exactly the kind of thing you don't want to see in an expanding retailer.

FY Ended 1/29/2005

FY Ended 1/28/2006

FY Ended 2/3/2007

LTM 5/7/2007

Gross Margin

43%

45.2%

44.7%

44.5%

Operating Margin

8.1%

8.4%

8%

7.5%

Cash Flow Ops Margin

11%

13.2%

10.5%

10.9%

FCF Margin

3.1%

2.9%

0.4%

0.8%

Data from Capital IQ.

Brrrr. Operating margins are moving in the wrong direction and they're still far below retail industry leaders: Abercrombie & Fitch (NYSE:ANF) keeps them near 20%. The final monstrosity in Coldwater Creek was, for me, the return on invested capital. My lease-adjusted figures show returns in the 10% range -- less than half what we see at Abercrombie.

Betting the smart odds
Now, by looking at a few simple measures of Coldwater's success (or lack thereof), what we know becomes perfectly clear. The only mystery here is how the prospects could have looked good to anyone paying close attention, especially when the stock was trading at such a premium: My data show an average three-year P/E ratio of more than 44 for Coldwater Creek. Clearly, great things have been expected at Coldwater, so anything less than "great" -- such as today's "terrible" -- would drown the share price.

Kudos to the writers at Forbes, who looked at the obvious and decided that Coldwater Creek was one mighty dangerous small cap. Golf clap for the rest of "The Street," which has been selling off Coldwater for some time now -- though to judge by today's 22% hemming, not selling aggressively enough.

Foolish final thought
Margins, investment returns, and divergent trajectories between sales and earnings growth. ... These things are clearly not as exciting as a trip to the mall or a jargon-filled wish list from a seemingly in-the-know analyst. But these metrics allow you to know what you know, and make your investments accordingly. Investing isn't about being right all the time, but when you are wrong -- and you will be -- you want to know that you were wrong for the right reasons. Over time, betting the smart odds will work out in your favor.

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At the time of publication, Seth Jayson, a top-10 CAPS player, had no positions in any company mentioned here. See his latest CAPS blog commentary here. View his stock holdings and Fool profile here. Fool rules are here.