Boom or Bust: Gold-Rush Stocks

Traditional value investors say dump the high-P/E stocks and buy low ones. What's your strategy?

Thanks to an investing education culled from the likes of Buffett, Graham, Siegel, and Neff, I tend to doubt stocks that push excessively high price-to-earnings ratios. But what do we really know about the performance of stocks that have historically reached very high levels of speculative value?

Most investors remember the big blow-ups. Others remember companies that went on to defy the value hawks -- witness Google's (NASDAQ:GOOG) rise since its IPO. But what would a closer study have to say about the subject?

Enter the data
Back in 2000, two speculators, Victor Niederhoffer and Laurel Kenner, attempted to do exactly that. The pair took the constituents of the Nasdaq 100 in years 1997, 1998, and 1999 and organized them according to their E/P multiples (simply the inverse of P/E). Using these rankings, the writers assembled data based on the respective percentage return in the year subsequent to the measurement. Here's what they found:

1. The 44 companies with negative E/P ratios (meaning they had negative net income) returned an average of 100% the following year.
2. The 183 companies that had E/P ratios of 0 to 0.04 (a minimum P/E of 25) returned 72%.
3. Finally, the 44 companies with the highest E/Ps (or the lowest P/Es) returned, on average, 47%.

Before you rush off and buy the stocks that fit this categorization, understand that this is an imperfect study. We now know 1997 to 1999 as bubble years. On top of that, the Nasdaq 100 is hardly a perfect sample. So take the results of the study with a rather large grain of salt -- probably more like one of those huge blocks of salt that horses lick.

Still, the data makes me curious.

Death or dynamite?
Niederhoffer is perhaps best known for his strategies that have seen both tremendous success and massive failure. And at the end of this particular study, he offered 12 stocks he believed to be "candidates for superior performance."

What has become of these 12 supposed candidates for superior performance since 2000?

So what kind of conclusion can we draw here? Well, it's clear that Niederhoffer did tap into some winners. Amazon, Legato, and Nextel are fine companies that have delivered excellent value to investors. And despite just beating the market over that period, EchoStar was another decent pick.

Don't bank on it
But look at the rest of the list. I'm not inspired. Sticking with the strategy would have you 53% in the hole today.

What we do know is that this screening tool seems to produce stocks that have a volatile future ahead. What are some of the names making the list today?

Beat the rush
Though you'll find plenty of excitement and potentially big returns when it comes to high-risk, high-reward investing, this method of identifying companies just doesn't cut the mustard. After all, the lowest E/P (remember: the highest P/E) indicates nothing more than a lot of market optimism.

What made companies such as Amazon and Nextel different, however, is that their businesses aimed to do something different and better than their peers and revolutionize the consumer experience in the process. At The Motley Fool, we call companies that can achieve this Rule Breakers.

Our Rule Breakers growth-investing service focuses on business quality when it comes to finding great growth stocks. We'll end up paying seeming premiums for some and get others on the cheap, but what we're looking for is a company that -- like Amazon -- has the potential to radically change the way the world does business.

Those that do will provide fantastic returns over the long term, whether we buy them "high" or "low" today. If you'd like to take a look at the stocks we're recommending today, click here to try the service free for 30 days. There is no obligation to subscribe.

Rule Breakers analyst Nick Kapur owns no shares of any company mentioned above and he definitely does not use this particular screen to find investment opportunities. Vertex Pharmaceuticals is a Rule Breakers recommendation. Amazon.com is a Stock Advisor selection. The Motley Fool has a disclosure policy.