Friday, April 8, 2011

The faster they rise, the harder they fall

I realize I butchered the original saying in the headline, but the original saying doesn't quite fit the point of this installment...which is, beware of high flying stocks when they run out of gas because they can go down - and they can go down fast.

Don't get me wrong - I love high flying stocks. In the past several months I have owned Netflix (NFLX, up close to 300% over the past year), Baidu (BIDU, up about 240% in the past year), Potash (POT, up 100% in the past eight months), and Freeport McMoran (FCX, about double since last June).

High flyers are a great way to make good money in a portfolio, but they hold some hazards as well. At some point, the fast gains made by these stocks push them far beyond a price that makes any rational sense. Does the word "bubble" bring back bad memories? High flyer stocks can eventually become one-stock bubbles just waiting for a chance to "pop and drop." That spells bad news if you aren't paying attention or refuse to believe there is an end to the dream. When a high flying stock falls out of bed, it falls hard - if you were late getting in on the stock, you can see all your gains disappear and end up with a loss in a matter of days.

I just had that experience with Netflix. This has been a great stock for the past year or more and the story is compelling. However, anyone will tell you that the stock is way, way overbought and the price is much too high. In fact, one Wall Street analyst has been telling anyone that will listen that the $234/share NFLX stock is logically worth about $70/share. I was late getting in, but finally bought some Netflix awhile back and made a quick 15% gain. But after I had it a few weeks, I started to get nervous. Having gotten in so late is a dangerous game to play, and the stock market hit a tiny bump and in two days my 15% gain was cut in half. I got out at that point and took my 8% gain.

If you want to play in the high flyer stock category, here are some things to remember: (a) Try to get in as early in the rise as you can, (b) Pay close attention to the stock. Don't expect it to go up every single day and think the sky is falling if it has a small drop now and then but don't let it ride indefinitely, (c) Get out, at least partially, if you think the sky is about to fall.

Regarding getting out partially, that is  a pretty useful strategy to keep in mind. Let's take NFLX as an example, and assume you were astute enough to buy 30 shares a year ago at $84 (an investment of $2,520). By January, 2011 the stock was $184. So you would have been up $100 per share. You want to hedge your bet a little bit, so let's say in January you sold 15 shares at $184 for $2,760). You have already guaranteed yourself a profit of $240, which is about 9%. That's a darn good rate of return for a year, you wouldn't make that in 5 years on a CD. But you also still have 15 shares of NFLX left. Move forward to April, 2011 - NFLX is now $234 and looking like it could be running out of steam. You are definitely in a great position - you can sell off more shares, let's say 10 more shares for $2,340. Now your guaranteed return is about 100%, you have doubled your money. Plus you still have 5 shares of NFLX valued currently at $1,170. At this point, Netflix could go the way of Blockbuster and you would still have doubled your money. But chances are that won't happen.

In essence, the concept above lets you play with the "house's money" instead of your own. It removes much of the risk of investing in high flying stocks. Yes, you do lose some potential gain by hedging your risk, but you have bought yourself some excellent insurance.

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