Which Stock Falls First?

In today's market, buying a rocket stock just before it takes a nosedive is every investor's worst nightmare.

Finviz.com publishes a daily list of stocks whose shares have just hit new 52-week highs. Every day, investors read the list and tremble -- some with greed, others with terror. Within our Motley Fool CAPS investing community, these top stocks generally enjoy favorable ratings, since everyone loves a winner. But not always:

Companies selected by screening for new 52-week highs hit on the Friday before publication. Low and recent price provided by Yahoo! Finance. CAPS ratings from Motley Fool CAPS.

When a stock hits a new 52-week high, it's only natural to wonder whether its next step will be the proverbial "doozy." It could happen. Look hard enough, and you can find a flaw in any stock:

• Take Costco for instance. Sure, it's five-starred on CAPS. It's also said to be benefitting from high gasoline prices, as shoppers merge trips to the Costco gas station with buying cheap groceries in bulk. Regardless, at a 2.0 PEG ratio, the stock's anything but cheap.
• Yum! Brands is harder. The stock's got good free cash flow and a decent dividend. But its 23 P/E looks a bit pricey for the 13% growth rate it's expected to produce.
• McDonald's is easier. 10% growth on a 17 P/E stock is pretty obviously overpriced. Plus, the company also generates inferior free cash flow relative to its net income, and carries a heaping helping of debt on its balance sheet.
• Picking on Level 3 is perhaps easiest of all. Analysts have this stock pegged for just 1% annualized earnings growth over the next five years. The stock's profitless for the past 12 months, carries $6 billion in net debt, and pays no dividend at all. If I had my druthers, Level 3 would be my choice as the stock most likely to fall this week.

Regardless, Level 3 is not the choice of CAPS members, who tag an entirely different company with the dread two-star, below-average performance label. According to our community of lay and professional investors, GameStop is the mo-mo with the least mojo on today's list. But why?

The bear case against GameStop
All-Star investor Gordogato explains: "Game publishers are heading in the direction of selling games through direct download, cutting out middleman sales outlets like GameStop. This also cuts off the ability of gamers to resell their used games through GameStop, since there is no physical media and you have just purchased a one-time use license key. Bricks-and-mortar stores selling games will disappear in the coming years, and bigger stores can sell the hardware more efficiently than the smaller chains like [GameStop]."

CAPS member TXinvestor82 agrees, arguing that the company is based on "a failing business model," and wondering aloud: "Will kids still be shopping at GameStop in three years?"

Hondamikesd doubts it: "Video game publishers are quickly tiring of losing revenue to the secondary market for their wares, expect digital distribution to be the primary (if not only) method of content delivery within the next one or two generations of consoles. Unless Gamestop gets into an entirely new business they're going to be the next in a line of retailers that includes the likes of Tower Records, Sam Goody, Blockbuster, and Borders."

I agree.

Game over for GameStop
Oh, I know. I'm the same Fool who told you last year that GameStop was a good buy. So how can I change my mind now?

Easy: Because the facts changed. For one thing, I was right about GameStop back then. Since I tapped GameStop as an outperformer last July, the stock has indeed beaten the S&P 500's performance. But at the same time as the stock's price has soared, its value has deteriorated. Last year, GameStop reported $408 million in net "profit" under GAAP. But its actual free cash flow totaled just $393.6 million. That's quite a contrast from 2009, when free cash flow eclipsed reported income by 27%.

Management hasn't deigned to show us a cashflow statement from last quarter yet (tsk, tsk). As a result, it's hard to say precisely what GameStop's free cash flow number looks like now. But we do know that sales for the first quarter of 2011 rose 9.5% in comparison to last year. Meanwhile, inventories were up 13.4%, and receivables rose more than 40%. In an industry where content is going ever more digital, rising levels of physical inventories are not a good thing -- especially when they're growing faster than sales.

Foolish takeaway
Already, the numbers at GameStop have turned, and begun to reflect the weak business model our Foolish commentators described up above. As game-makers like Electronic Arts (Nasdaq: ERTS) and Activision (Nasdaq: ATVI) increasingly migrate to digital business models, GameStop's going to become less and less relevant to consumers, and earn fewer and fewer of their entertainment dollars. If it's not yet "game over" for GameStop, it certainly looks like the beginning of the end.

Or at least, that's my opinion. But don't just take my word on it. Click over to Motley Fool CAPS and tell us what you think.