2 Fallen Growth Stocks: 1 to Buy & 1 to Sell!

Brian is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

A large downtrend is often a normal part of any stock’s life cycle. There are very few stocks that see massive runs higher that then don’t experience at least one 40% swing lower (i.e., Netflix, Green Mountain Coffee Roaster, Apple). This swoon can often create opportunity to repurchase the stock at a much cheaper price, as it usually realigns expectations with growth. Here, I am looking at two such stocks that have seen a large downtrend to determine if a reversal is in play or if the downtrend was part of a larger problem.

Questcor Pharmaceuticals (NASDAQ: QCOR)

If you would have invested just $5,000 in Questcor Pharmaceuticals back in 2007 and then had sold it in June of last year you would have made more than $700,000 (not bad huh?)! However, last year a combination of insurer restrictions on its drug Acthar, an investigation into its marketing practices, and a bearish outlook from short-seller Citron Research created a sudden shift in perception, as overly optimistic investors suddenly became pessimistic, and the stock lost almost 70% of its value in three months.

For those of you who bought at the end of September, you have enjoyed a very nice gain of 70%. Since bouncing off its lows the stock had traded in a very tight range around $25, with one very brief run to $30. However, over the last month we have seen a sudden rise of 22.50%, and a stock that has now exceeded $32. Therefore, what happens now?

When you look at what created the selling pressure in shares of Questcor, it was in fact speculation. However, the fundamentals suggest that this is a company that is still more than doubling year-over-year and with a forward P/E ratio of 6.20, it is cheaper than at any period over the last five years.

Furthermore, I’d add that it’s more attractive now as a long-term investment, because one thing that the sell-off created was a change in the behavior of management. Prior to the sell-off the company was relying on just one product, but since then, management has acquired a clinical company and has implemented both a share buyback program and a dividend. Therefore, QCOR is now a stock that is cheap that also has a forward yield of 2.60%, and is a fast-growing company that I say is a definite buy.

Mellanox Technologies (NASDAQ: MLNX)

After a four-year 1,100% return, shares of Mellanox Technologies took a sudden turn for the worse late last year. The losses began when the company issued guidance that was a couple million dollars short of expectations, and the market overreacted. However, in the last two quarters, the company has come out and issued even worse guidance leading some to believe that there is a long-term fundamental shift occurring, from Mellanox being a growth company to a maintenance company. In fact, during its last quarter, the company guided for Q1 revenue between $78 million and $83 million, 40% below the consensus.

In what seemed like overnight, Mellanox went from a company with growth of 150% to a company with growth of 68% to now issuing Q1 guidance for near flat growth yoy. For the last year there has been some speculating that Intel would create too strong of competition and that sales could fall flat. Yet management insists that its recent fall is temporary, caused by seasonal weakness and a $30 million inventory buildup that slowed sales.

Therefore, after a very sharp decline, investors have begun to buy back shares, and the stock has seen a 15% rise during the last week following news of a recent partnership, combined with news of its InfiniBand adapter cards being used in a high-end server data warehousing system developed by Microsoft. Investors view these catalysts as two that could produce fundamental growth, and now expect to return long-term gains with the inventory issues a thing of the past.

The problem with Mellanox is that it’s hard to determine what’s next from management. For the last two quarters the guidance has been disappointing, and management always insists that it’s a one-time event that is creating weakness. Perhaps retail investors are right and now the company will continue to grow.

However, I find the guidance of the last two quarters to be hugely disheartening, almost creating distrust towards management. Therefore, I want to see the company’s upcoming quarter before I say to buy. At this point, it’s projecting zero growth yet trades at 22.50 times earnings, which I consider expensive for zero growth. As soon as the company reaffirms growth then my outlook will change, but until then, I use recent history as an indication that there could be more surprises on the horizon, and that 22.50 times earnings is too expensive for a stock with such uncertainty.

Conclusion

In my book, Taking Charge With Value Investing (McGraw-Hill, 2013), I discuss market psychology and teach investors how to capitalize on the illogical behavior of the market. One of my fundamental teachings is that price dictates outlook, and that by understanding this very basic philosophy you can remain one step ahead of a panic-happy market. The key is to determine if loss is fundamentally warranted, or if it was due to a change in perception. If the latter, you can find distinctions between fundamentals and market behavior to return very large gains when a stock reaches the bottom of a trend lower. In my opinion, the above stocks are an example of both scenarios, and in time we will see if I am correct. 


Brian Nichols is long QCOR. The Motley Fool has no position in any of the stocks mentioned. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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