Rocket Stock or Dud?

"The bigger they are, the harder they fall." It's the worst nightmare of every investor in today's market -- buying a rocket stock just before it takes a nosedive.

Now I readily admit that sometimes, stocks rise for a reason. But sometimes, the rise becomes the reason. No matter how often we caution them not to, investors do have a habit of buying "hot" stocks, and trusting momentum to keep 'em moving upwards.

Problem is, if the price goes up too much, even a great company can turn into a lousy investment (and if the company was less than great in the first place...) Below I list a few stocks that may have done just this. Stocks that, according to the smart folks at finviz.com, have doubled (or nearly so) over the past year, and just might be ripe to fall back to earth.

Companies are selected by screening for 100% and higher intraday price appreciation over the last 12 months on finviz.com. Five stars = highest possible CAPS rating; one star = lowest. Current pricing provided by Yahoo! Finance. CAPS ratings from Motley Fool CAPS.

Question: What does oil refining have in common with cancer research? What do either of these things have to do with Indian Internet service providers?

The answer is that the companies behind these endeavors boast some of the hottest stocks on the market today. Even as the price of its major input product soared, Tesoro shares have managed to more than double over the past year. YM BioSciences has done about the same as Tesoro, while Sify has done even better, rising 277% since this time in 2010.

[Pause for applause.]
Congratulations all around. But now that the stocks have taken their bow, it's time to ask the important question: They've all done well over the past year, but which of these companies will excel over the rest of 2011?

According to CAPS All-Star IBDvalueinvestin, Sify's set to "become a major player in 2nd half of 2011 from Europe to India." Fellow Fool contributor Rick Munarriz likes the stock as well. Back in January he declared this Indian IT specialist a better idea than Rediff (Nasdaq: REDF), for Fools seeking to capitalize on "India's dot-com upgrade." (The stock has obligingly doubled since then.) And CAPS member imshirazy notes "the number of institutional holdings has increased dramatically." And YM Bio offers "promising drugs with upcoming PIII trials."

And yet while both these stocks have their fans, neither one enjoys the broad-based CAPS support that Tesoro boasts. In fact, with four CAPS stars to its credit, you could even say Tesoro is about as popular as two-starred Sify and YM Bio combined. But why?

The bull case for Tesoro
CAPS member cubmonkeysheep gives us one clue: "This small San Antonio company supplies the Pacific Rim (think Japan) with oil. Since their nuclear power will not be back for sometime" you might want to buy Tesoro now. curt00 sees a second catalyst in the fact that the "crack spread" (essentially, the profit margin a refiner earns on its product) "is widening."

But it wasn't always so. CAPS member Option1307 picked Tesoro to outperform more than a year ago, and has outperformed the market by better than 100 percentage points on the pick. How? In the member's own words from last month:

As I've stated many times the past 6 months, you really can't go wrong buying into the refining sector right now. Things are down and people absolutely hate refiners right now ... This whole sector has been loosing massive amounts of money the past 1-2 yrs, crack spreads have not been kind to them lately ... However, the thing to remember with refiners, is that they may be cyclical in nature, but when they are up, they're up big! They may be loosing money at a high rate now, but this will not continue forever. Eventually they will return to the mega cash machines that they can be.

Indeed, Tesoro's own earnings dropped steadily from 2006 through 2009. Last year, the company lost $29 million (as calculated under GAAP), and didn't do much better free cash flow-wise. The mere $88 million in free cash flow the company generated values the company at a whopping 45 times free cash flow today! And of course, it's unprofitable under GAAP. Say what you like about the P/Es at rivals Frontier Oil (NYSE: FTO) or Valero (NYSE: VLO); at least those two are still profitable.

And yet, as Option1307 points out, refining is a cyclical industry. Oil prices might be high now, and squeezing Tesoro's margins, but this won't last forever. In fact, if you examine how the company has performed over long periods of time, from 2005 to 2009 Tesoro actually generated an average of $414 million in annual free cash flow, roughly in line with its reported average net profit of $402 million. Based on these numbers, Tesoro's $4 billion market cap values the company at less than 10 times average annual earnings and free cash flow, alike -- which seems reasonable.

Time to chime in
Sure, the safest thing to do in an industry like this is probably to buy a diversified operator like ExxonMobil (NYSE: XOM), whose drilling operations allow it to make profits upstream when oil prices are high, and whose refineries benefit when oil costs decline. But if you're looking to ride a rocket like Option1307 did, it seems to me that buying Tesoro today, when it still looks unprofitable -- but isn't -- is the better bet.

Of course, that's just my opinion. If you disagree -- feel free. Click over to Motley Fool CAPS right now, and tell us why.