3 Keys to Avoid Riding a High-Flying Stock DOWN

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When I see high-flying stocks, like Green Mountain Coffee Roasters (NASDAQ: GMCR) and Netflix (NASDAQ: NFLX), come crashing down -- they're down about 75% and 52%, respectively, over the past year -- Kenny Rogers' tune "The Gambler" pops into my mind. 

"You got to know when to hold 'em, know when to fold em, know when to walk away and know when to run...                                         

Now ev'ry gambler knows that the secret to survivin' is knowin' what to throw away and knowing what to keep. Cause ev'ry hand's a winner and ev'ry hand's a loser..." 

Other than being a darn catchy tune, there is some wisdom applicable to things beyond just gambling -- like people, situations...and stocks. 

Know When to RUN                   

While it may not be a warm summer evening, and you and I aren't on a train bound for nowhere, I'm going to pick up where Kenny's gambler left off. Knowing when to run from -- sell -- a stock can be difficult, even for  experienced investors.   

I want to be clear -- this article is NOT about how Green Mountain's stock looks going forward, so if you're looking for that type of analysis, you'll need to look elsewhere. This article's purpose is to show how investors might have recognized red flags and sold near the high -- or, in Kenny's words, at least not let their winning hand turn into a losing one. The content is meant to be general; I am using Green Mountain as it helps to have an example.  

Please note that I'm not criticizing anyone whose winning hand turned into a losing one, or meaning to be a Monday Morning Quarterback -- we all know how easy that is. The info here is meant to be helpful for potential or existing investors in any stock going forward. 

In most cases, there are red flags in advance of a stock's crash. And in most cases, there is not one sudden 50% plunge, but rather several legs down. That said, Green Mountain's stock did drop over 35% in early Nov. 2011 after the company missed revenue expectations. But the magnitude of that drop was likely due, in part, to hedge fund manager's David Einhorn's infamous bear-stance presentation on the stock the previous month. And there were a couple upturns over the ensuing few months that offered decent prices to sell into.

In any event, there were red flags present before Einhorn's presentation.   

1. Competitive Advantage is Slipping 

Buy stocks in companies that have sustainable competitive advantages and sell the stock of any company once the writing on the wall says, "the competitive advantage is disappearing."

Signs a company's competitive advantages are slipping or will likely soon slip:

  • Profit Margins are shrinking 
  • Key Patents are expiring -- Red Flag 1 for Green Mountain

There are others, of course. And just because key patents are expiring does not necessarily mean the company is in trouble. However, it is cause to examine the situation.

As to Green Mountain, two key K-Cup patents expired on Sept. 16. The company derives over 75% of its revenue from K-Cups. (There is disagreement as to how much cheaper coffee cups will hurt sales and profits. Addressing that question is not the purpose of this article.) The patent expiration issue news was out well in advance.

Competitive advantages include:

  • Brand strength and customer loyalty 
  • Patent protection
  • Financial muscle pertaining to distributors and/or suppliers   
  • High barriers to entry related to huge capital expenditures and/or regulations to enter industry 

Apple (NASDAQ: AAPL) comes to mind as a company with great brand strength and customer loyalty, as well as financial muscle and economies of scale, especially pertaining to suppliers. And, of course, there are those patents that were recently all over the news. Like Apple -- though usually for different reasons -- Amazon (NASDAQ: AMZN) is often cited as a high-flying stock. But, also like Apple, its notable strengths are its brand, as well as financial muscle relating to economies of scale. In fact, Interbrand just released its annual Best 100 Global Brands -- Apple and Amazon were two of top movers from last year, moving to #2 and #20, respectively. 

Consumers are generally fickle, so counting on just brand strength is usually not enough. The consumer gadget world and apparel industry are littered with companies whose stocks soared when their widget, apparel or footwear were popular only to fizzle when the brand lost its cache.  

And patents?

Patents can be great barriers to entry, but there can be issues with companies whose primary competitive advantage is patented design, technology, or whatever.

First, patents can be kind of fuzzy, and a competitor who wants to produce a similar product, but one that doesn't infringe on others' patents can sometimes do so. The risk is greatest for simpler products. Very complex technologies -- such as Intuitive Surgical's da Vinci surgical systems -- are a different story.

Second, patents expire. The concern is when a company is not diversified. Pharmaceutical companies rely heavily on patent protection, though formulation patents are generally more clear-cut than design- or tech-related ones. However, beyond the very small start-ups, you almost never see a company with just one patented drug. They spend heavily on R&D because they know they need a steady product pipeline.

Third, patent litigation is time-consuming and costly.

2. Consistent Disconnect between Cash Flows & Earnings  

You know how the attention-seeking types often seem to have less substance than the rest of us? Well, think of them as a company's earnings -- they garner a lot of attention, but can be full of hot air.

Many investors get caught up in earnings and seem to believe they are "real." Reported net income, or "earnings," is just the number that comes out when the accounting is done. It can have little resemblance to what we think of in real life as income or earnings. That's a company's "cash flow" -- and, in this Internet age, it's a snap to check it.  

Free Cash Flow

Generally, when you see "cash flow," the reference is to "free cash flow." This is the cash generated after all is said and done. If FCF is equal to or greater than reported earnings, you can usually stop there. This is a good sign. If FCF is less than reported earnings -- and it often will be -- you need to account for why. FCF will often be less than earnings for good reasons -- like spending on investments and/or paying dividends. However, you don't want a company overspending either.

Operating Cash Flow

There is another cash flow that you should look at -- "Operating Cash Flow." This is the cash flow generated solely from the company's operations -- costs to run the biz subtracted from revenue generated. This is the cash situation before investments and financing are taken into account to arrive at FCF. If a company is generating positive earnings and negative operating cash flow, there is often an issue.

This was Red Flag 2 for Green Mountain. 

Cash Flow Statement (from Yahoo! Finance)  

The reported net income is at the top. Then "adjustments" are made to reflect the true cash position. Those huge inventory and A/R adjustments are big concerns. The take-homes:

  • You do NOT want to see negative operating cash flows (Fiscal Year 2010).
  • You also do NOT want to see operating cash flow significantly lower than reported net income (FY 2011).

A one-off quarter or two is one thing, but we're talking two years.

<table> <tbody> <tr> <td> <p>Period Ending</p> </td> <td> <p><strong>Sep 24, 2011</strong></p> </td> <td> <p><strong>Sep 25, 2010</strong></p> </td> <td> <p><strong>Sep 26, 2009</strong></p> </td> </tr> <tr> <td> <p><strong>Net Income </strong></p> </td> <td> <p><strong>199,501 </strong></p> </td> <td> <p><strong>79,506 </strong></p> </td> <td> <p><strong>54,439 </strong></p> </td> </tr> <tr> <td colspan="4"> <p> </p> </td> </tr> <tr> <td colspan="4"> <p><strong>Operating Activities, Cash Flows Provided By or Used In</strong></p> </td> </tr> <tr> <td> <p>Depreciation</p> </td> <td> <p>119,794</p> </td> <td> <p>45,319</p> </td> <td> <p>23,846</p> </td> </tr> <tr> <td> <p>Adjustments To Net Income</p> </td> <td> <p>19,782</p> </td> <td> <p>28,386</p> </td> <td> <p>15,468</p> </td> </tr> <tr> <td> <p>Changes In Accounts Receivables</p> </td> <td> <p>(157,329)</p> </td> <td> <p>(102,297)</p> </td> <td> <p>(52,963)</p> </td> </tr> <tr> <td> <p>Changes In Liabilities</p> </td> <td> <p>141,881</p> </td> <td> <p>69,418</p> </td> <td> <p>37,064</p> </td> </tr> <tr> <td> <p>Changes In Inventories</p> </td> <td> <p>(375,709)</p> </td> <td> <p>(116,653)</p> </td> <td> <p>(47,650)</p> </td> </tr> <tr> <td> <p>Changes In Other Operating Activities</p> </td> <td> <p>51,318</p> </td> <td> <p>(5,976)</p> </td> <td> <p>8,413</p> </td> </tr> <tr> <td> <p><strong>>>>Total Cash Flow From Operating Activities <<<</strong></p> <p><strong>"Operating Cash Flow"</strong></p> </td> <td> <p><strong>785 </strong></p> </td> <td> <p><strong>(2,297) </strong></p> </td> <td> <p><strong>38,617 </strong></p> </td> </tr> <tr> <td colspan="4"> <p> </p> </td> </tr> <tr> <td colspan="4"> <p><strong>Investing Activities, Cash Flows Provided By or Used In</strong></p> </td> </tr> <tr> <td> <p>Capital Expenditures</p> </td> <td> <p>(283,444)</p> </td> <td> <p>(126,205)</p> </td> <td> <p>(48,298)</p> </td> </tr> <tr> <td> <p>Investments</p> </td> <td> <p>499</p> </td> <td> <p>51,788</p> </td> <td> <p>(50,000)</p> </td> </tr> <tr> <td> <p>Other Cash flows from Investing Activities</p> </td> <td> <p>(904,727)</p> </td> <td> <p>(459,018)</p> </td> <td> <p>(41,318)</p> </td> </tr> <tr> <td> <p><strong>Total Cash Flows From Investing Activities </strong></p> </td> <td> <p><strong>(1,187,672) </strong></p> </td> <td> <p><strong>(533,435) </strong></p> </td> <td> <p><strong>(139,616) </strong></p> </td> </tr> <tr> <td colspan="4"> <p> </p> </td> </tr> <tr> <td colspan="4"> <p><strong>Financing Activities, Cash Flows Provided By or Used In</strong></p> </td> </tr> <tr> <td> <p>Dividends Paid</p> </td> <td> <p>-</p> </td> <td> <p>-</p> </td> <td> <p>-</p> </td> </tr> <tr> <td> <p>SalePurchase of Stock</p> </td> <td> <p>980,409</p> </td> <td> <p>8,788</p> </td> <td> <p>394,941</p> </td> </tr> <tr> <td> <p>Net Borrowings</p> </td> <td> <p>223,317</p> </td> <td> <p>276,283</p> </td> <td> <p>(45,717)</p> </td> </tr> <tr> <td> <p>Other Cash Flows from Financing Activities</p> </td> <td> <p>-</p> </td> <td> <p>-</p> </td> <td> <p>-</p> </td> </tr> <tr> <td> <p><strong>Total Cash Flows From Financing Activities </strong></p> </td> <td> <p><strong>1,199,845 </strong></p> </td> <td> <p><strong>298,322 </strong></p> </td> <td> <p><strong>342,006 </strong></p> </td> </tr> <tr> <td> <p>Effect Of Exchange Rate Changes</p> </td> <td> <p>790</p> </td> <td> <p>-</p> </td> <td> <p>-</p> </td> </tr> <tr> <td> <p><strong> </strong></p> </td> <td> <p><strong> </strong></p> </td> <td> <p><strong> </strong></p> </td> <td> <p><strong> </strong></p> </td> </tr> <tr> <td> <p><strong>Change In Cash and Cash Equivalents </strong></p> <p><strong>"Free Cash Flow"</strong></p> </td> <td> <p><strong>8,588 </strong></p> </td> <td> <p><strong>(237,410) </strong></p> </td> <td> <p><strong>241,007 </strong></p> </td> </tr> </tbody> </table>
Source: Yahoo Finance -- highlights ">>>" and cash flow terminology mine


3. Insiders are Selling Big-Time

When insiders -- especially very top ones, such as the CEO and CFO -- are selling their stock big-time and en masse, you should strongly consider selling, especially if there are other red flags. The CEO, CFO and a few other top insiders sold over $125 million of stock on just two days alone, Aug. 4 and 5, 2011. 

Some insider selling is to be expected -- you can't blame people for wanting to convert some of their paper wealth to real dollars. And sometimes money is needed for large purchases. Again, we're talking big-time and en masse selling. 

This was Red Flag 3 for Green Mountain.

Price of stock on Aug. 4 and 5, 2011?

The two-day range was $92.13 to $109.7. The all-time intra-day high was $115.98 hit on Sept. 20, and the all-time closing high was $111.62 on Sept. 19.  

Current stock price? $22.13 (close on Oct. 5).

<img src="http://media.ycharts.com/charts/3bfd07c3b6cfef7ff0989a6c06555752.png" />

GMCR data by YCharts

Foolish Bottom Line 

When evaluating a stock for a possible buy or when monitoring an existing stock holding, it's important to do two things that are often neglected:

1. Check the Cash Flow Statement

2. Keep on top of insider sales



BAMcKenna has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple, Amazon.com, and Netflix and has the following options: long DEC 2012 $16.00 puts on Green Mountain Coffee Roasters and short DEC 2012 $21.00 calls on Green Mountain Coffee Roasters. Motley Fool newsletter services recommend Amazon.com, Apple, Green Mountain Coffee Roasters, and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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