Most days, the market might seem a pretty stable place. Frenetic, yes, but relatively stable. But on any given day, there are tragedies. Last Friday alone, I watched Merge Healthcare sink 25% before leveling off at a mere 16% loss. Dana dropped a heart-stopping 52%.
Why do companies take dives like this? Well, they were standing on the brink, and they took one step too many toward the wild blue yonder. Are you hanging on to companies with similar risks? Maybe. Read on to learn how to spot them for yourself.
Business on the brink
There are a lot of companies out there that really are one step away from diving off the cliff. Cherokee (NASDAQ:CHKE), for example, is a company I like -- and own -- but one I would classify as "living on the edge."
There are some serious risks here. They are, in fact, inherent in the business model, which is licensing its brand names to stores like Target (NYSE:TGT) who then sell apparel under that mark. "Wait a minute," you ask? "Cherokee doesn't actually make anything?" You got it, bub. And on top of that, it produces great free cash flow, grows steadily (if not quickly), and pays a very healthy dividend, about 6% these days.
Sign you up? Not so fast. Let's look at how Cherokee flirts with disaster. It's that sweet relationship with Target, which provides a full 51% of Cherokee's revenues, and is up for renewal in 2007. It's conceivable that Target might just chuck the Cherokee brand and do something on its own. After all, Wal-Mart (NYSE:WMT) has begun just such a home-grown strategy, putting together a women's line called Metro 7 in an attempt to update its image and garner some brand loyalty.
If Target went the same route, Ouchies for me.
A large concentration of revenues with a single source is one of the primary ways businesses can put themselves on the brink. It's one of the reasons loan-services company First Marblehead got so cheap a few months back. Operating under govenment largesse -- like Headwaters -- is another. Working in areas that Uncle Sam would like to control -- or even ban outright, like gambling -- watch out.
The 10-K will tell you if your company is in this kind of jeopardy, but before we get to what you should do with that kind of knowledge, let's look at a far more common investor risk.
Share price on the brink
Here's the real danger for most investors. Even if you have good companies with solid sales and earnings growth, share-price disasters are always close at hand. In fact, the better the growth, the more likely the share-price disaster. And these share-price bombshells do not require a problem with the business.
Google is a prime example. Only weeks ago it was sailing past the high $400s, on its way to $2,000 a share -- by some crazy peoples' estimation -- when, oops, it put in a good earnings report. That's right, a good earnings report. The result for shareholders? How about a 20% haircut?
What was the danger here? Expectations. Google is always supposed to beat analyst estimates. Trounce them, in fact. But Google couldn't do it this time around, and that nudged shares right off the cliff.
This sad tale is, alas, nothing new. IBM (NYSE:IBM) has pulled this trick many times over its history, as did companies as diverse as McDonald's, Johnson & Johnson, and Schlitz Brewing. (Yeah, that last one mystifies me, too. I used to drink Schlitz -- if I couldn't get pondwater.) At the end of 1972, IBM actually had the most reasonable P/E of the companies listed above, at 33. Back then, Disney (NYSE:DIS) demanded a P/E of 82! But, just like Google now, these stocks were eventually rewarded with market beat-downs for the minimal sin of merely meeting earnings expectations.
Google? It's still trading at a P/E of 75, during a time when savvy Web retailers are determined to spend less on click ads. That's bad, and with Google still trading on high hopes, anything less than amazing is going to burn investors again.
Folks, the story never changes. Even if the business is good, the shares can be a disaster. Luckily, there's a way to avoid it.
It's all about the buy
Most businesses are walking the razor's edge in one way or another. That's why "value investors" (otherwise known as investors) have a couple simple rules. One is to buy companies that operate their businesses as far from the brink as possible. Consumer products giants like PepsiCo (NYSE:PEP) or Procter & Gamble (NYSE:PG) have such wide product offerings, and such well-known brands, that they can stay rooted in nearly any storm. Drug companies with full, patented portfolios can do likewise.
Picking stable or patent-protected businesses helps, but the real key to investing, whether on the brink or away from it, is price. That's right, price. If you never overpay, you simply don't suffer the same fate as the rest of Wall Street's repeat cliff divers.
How do you avoid overpaying? You do the math. I bought Cherokee, despite the very real Target risk, because I quantified that risk in my valuation model, and I bought the shares at a price that suggested a 20% margin of safety.
Staying away from the brink really is that easy. And best of all, once you make a habit of always demanding the low price for your shares, the few times you are wrong in your valuation, and topple off the cliff anyway, you won't fall as far.
Simple, safe, and away from the brink is way we strive to invest at Motley Fool Inside Value. If you need a bit of help with the math, a free 30-day Inside Valueguest pass will give you access to all our picks -- as well as the rationale behind them -- and automated tools to perform your own numeric analyses.
Seth Jayson was always better at math when the numbers came with dollar signs. At the time of publication, he had shares of Cherokee, but no positions in any other company mentioned. View his stock holdings and Fool profile here. Fool rules are here.
