Warning: 4 Signs Your Stock is About to Crash

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

How to you determine if your stock is about to tank? Vigilance. If you want to avoid steep losses in your portfolio you must constantly monitor the health of your holdings.

But big stock declines are rarely marked with bold warning labels. Financial statements are lagging indicators, management commentary is self-serving, and analysts rarely slap sell ratings on any stock.

However, there are subtle signs that foreshadow a stock’s collapse. Here are the top four red flags you should be on the lookout for.

Hubris

Success leads to arrogance, which can blind a company from the realities of the marketplace. There’s always a new competitor, technology, or development lurking, and leaders who don’t maintain a healthy paranoia are doomed.  Hubris can be spotted when management gets distracted with ego boosting side projects, grand acquisitions, or builds an impressive new headquarters.

In 2006, Research in Motion (NASDAQ: BBRY) was riding high on the success of their Blackberry smartphone. Bolstered by their triumph, ex-CEO Jim Balsillie spent most of his time trying to bring an NHL hockey team to Hamilton, Ontario.

Six years later, Google and Apple (NASDAQ: AAPL) now dominate the smartphone market with their Android OS and iPhone handsets. RIM is hemorrhaging market share, and shares of the company have plummeted 95%.

In late 2007, EnCana began construction of their new headquarters, The Bow skyscraper in Calgary, Alberta. The building will be the tallest west of Toronto and herald in Canada’s energy future.

Since construction began, natural gas prices have fallen 80%, and EnCana shares have been one of the worst performers in the energy business.

Public Awareness

Success in investing often comes from identifying a new theme before the masses do.

You were one of the early adopters of XYZ technology and saw potential before the street. Now the company has been featured on the cover of BusinessWeek and your brother-in-law is raving about the stock.

It’s time to split.

In 2000, no one is talking about gold, silver, or precious metals. China was an investment backwater.

Now, the gold and China theme is so well understood it’s used as a plot device in Hollywood blockbuster Looper. Time to sell SPDR Gold Trust (NYSEMKT: GLD), SPDR Silver Trust (NYSEMKT: SLV), and China.

Over Diversification

Developing new products and expansion into new markets is critical to the success and growth of any business. The trouble arises when management expands into industries that exist outside the core competency of the firm or doesn’t complement the main business.

Has your logging company announced it’s moving into the hotel industry? Did your computer hardware stock announce it was building a search engine? These types of expansions expose the company to new risks. Investor capital is usually squandered if management doesn’t have the skills needed to operate in the new industry.

In the early 1990's, General Motors begin an expansion into information technology and aerospace with the acquisition of Electronic Data Systems and Hughes Aircraft. These ventures only served as distractions from GM's core competency, building vehicles.

Excessive Growth

Sustainable organic growth can put incredible strain on a business. Breakneck expansion taxes the company’s cash flow, inventory, and business processes. Finding the right people, sustaining a corporate culture, and communicating vision is stressed if growth is not managed correctly.

By 2008, Starbucks (NASDAQ: SBUX) had over-saturated the market after 20 years of double digit growth.  Cafes doubled as gift shops as a result of the push for “incremental sales.” Employee training deteriorated. The company had lost touch with its mission to “serve great coffee.” Profits collapsed and the stock price tumbled 80%.

In 2000, the relentless pursuit for growth was beginning to strangle McDonalds' operating results. Stores became dirty and grimy, and the menu was scattered and un-targeted. Customers balked and shares of the fast food chain fell 75%.

Foolish Bottom Line

It’s important to note that advance warning signs of an impending stock collapse often don’t come from the financial statements. Losses will accumulate in your portfolio long before they show up on a company’s income statement. Investors must always be on the lookout for subtle clues that precede an implosion.

What advance warning signs do you look for when monitoring your investments?


RobertBaillieul has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple and Starbucks and has the following options: short JAN 2013 $47.00 puts on Starbucks. Motley Fool newsletter services recommend Apple and Starbucks. 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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