Stocks on Bubble Watch

Can you tell when a company's stock is about to implode?

Not many people, if any, have repeatedly shown the ability to predict a massive decline in a company accurately. But I have five steps that might offer you some assistance.

History serves an important lesson
Back in 2000, investors were blinded by an Internet world that was growing at a phenomenal rate. Many experts jumped on the tech bandwagon, but Wharton professor and writer Dr. Jeremy Siegel was among a small, vocal minority that failed to hear the siren song.

Siegel openly critiqued many Internet companies and their overly generous valuations, including networking giant Cisco Systems. This stock went from a high of $82 in 2000 to lows of $10.39 two years later, turning an investment of $10,000 into a pittance of just $1,267. In fact, it was Cisco that brought Siegel fame -- and perhaps infamy -- when he discussed the company on CNN's Moneyline.

He said: "It's a super company. I would probably buy it at 80 times earnings, but at 150 times earnings? We have six stocks in the top 20 (market value) over 100. We have had no history of this. Never have stocks been worth over a hundred times earnings once they've gotten to the size of these companies."

Remember when that happened?
The rest, as they say, is history -- with other giants such as Yahoo!, Oracle, and AMD shedding 80% or more. Siegel proved adept at identifying this dangerous trend and went on to write about it in The Future for Investors. While the book offers plenty of investing gems, I believe his five simple lessons for how to avoid losing money in a bubble are the most valuable:

1. Valuations are critical.
2. Never fall in love with your stocks.
3. Beware of large, little-known companies.
4. Avoid triple-digit price-to-earnings (P/E) ratios.
5. Never short sell in a bubble.

Three questionable calls
With an eye toward lessons 3 and 4, here are three stocks that may have gotten ahead of themselves:

Now, these companies might just go on to defy the odds. But I suspect you'll want to be on your game in case they come up short of expectations.

Look elsewhere
Instead, Siegel and other investing gurus suggest finding companies that don't carry rich valuations, have clear-cut business models, and offer more than just simple growth opportunities. But that's not all.

In his book, Siegel suggests that investors might want to look toward industries whose growth is below expectation and whose existence is under the average investor's radar. Why? A successful company in an underperforming industry can be explosively profitable, because it will "maximize productivity and keep costs as low as possible" while simultaneously outliving competition. This translates to significant bottom-line appreciation.

Take these three small-cap stocks, which have done just that in relatively sleepy industries:

Forget the hype
Chasing hot companies in hot industries will often leave you burned. In the long run, it's likely that a company's valuation will land squarely alongside its earnings capacity -- which is often unproven when a company sports a triple-digit P/E.

Instead, you'll be rewarded by buying shares of small companies in underfollowed industries that have demonstrated a real ability to make money. This is the strategy that we use at our Motley Fool Hidden Gems small-cap investing service, and our recommendations are beating the market average by more than 15 percentage points.

You can take a look at the stocks Hidden Gems is recommending today by joining the service free for 30 days. Click here for more information.

This article was originally published July 10, 2007. It has been updated.

Fool analyst Nick Kapur has no material position in any company mentioned above. Yahoo! is a Stock Advisor pick. The Fool has a disclosure policy.