Some Really Bad, No-Good, Awful Advice

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Back in early July, I penned an article about six stocks that could double within the next two months. My reasoning in selecting the stocks was broken down into two simple premises:

1. In business, innovation always wins out.

2. Heavily shorted stocks can jump on any sign of good news.

So I went out looking for highly innovative stocks, with a history of earnings beats that were heavily shorted. Two months later, the results are in:

Dismal!
Take a look below to see how my six selected stocks did. Because all of these companies reported earnings over the past two months, I show how they performed against analyst estimates, as well as what their average beat had been prior to the latest earnings release.
 

Company

Change Since July 1

Earnings Results

Average Beat Prior to This Quarter

Entropic (NAS: ENTR) (47%)Miss by 5.5%27%
Travelzoo (NAS: TZOO) (42%)Miss by 22%167%*
SodaStream (NAS: SODA) (40%)Beat by 33%119%
First Solar (NAS: FSLR) (23%)Miss by 24%36%
Coinstar (NAS: CSTR) (14%)Beat by 5%46%
Ebix (NAS: EBIX) (13%)Beat by 43%18%

Source: Google Finance, E*TRADE. *Excluding a one-time charge to the state of Delaware in the first quarter.

Though it's important to remember that over the same time period, the Dow Jones Industrial Average (INDEX: ^DJI) was down more than 6%, these results are awful. Instead of doubling, half of the stocks almost did the opposite: seeing their value cut in half!

Where I went wrong
I would like to think that my biggest mistake was not in the argument I laid out; I still believe that highly innovative companies win out in the long run, and that if they are heavily shorted, this could provide a turbo-boost to their stock price.

Rather, I think mine was an error of omission. First of all, the "long run" is measured in years and decades, not two months. Furthermore, stocks that are heavily shorted are just as likely to take a dive on the sign of bad news as they are to take a spike on word of good news. I didn't give that possibility enough space in my argument.

Throw on top of that the poor returns and volatility from the larger market over these two months, and I created a recipe for disaster.

Earnings misses
When a company is heavily shorted, or when it has a high P/E, it can't afford to come up short of analyst estimates. But that's exactly what happened with Entropic, Travelzoo, and First Solar.

For Entropic, this was due to weak demand from their largest customer, Verizon; Travelzoo was busy building out its Local Deals network, but the quarter ended before that spending could translate into revenue; and First Solar is still dealing with much weaker demand in Europe than in years past.

Modest beats, but unfavorable guidance
Both Coinstar and SodaStream beat analyst estimates, yet they were still punished by the market in the ensuing weeks. 

Coinstar had to deal with a double-whammy: The president of its Redbox segment announced his resignation in July, and the company reduced revenue guidance for the second quarter before earnings were announced.

For SodaStream, share prices fell off a 40% cliff after not changing their full-year guidance even with a 33% beat. That signaled to investors that management wasn't expecting anywhere near the growth that the market was pricing in.

Why no pop here?
This leaves us with the curious case of Ebix. The insurance software provider beat estimates by a whopping 43%, yet still suffered from the slings and arrows of the market.

The company has been hit in the past by accusations of growth purely via acquisition, as well as by the actions of their admittedly eccentric CEO, Robin Raina. The Fool conducted an interview with Raina recently, and the conversation had some Fool analysts salivating for Ebix shares.

Lesson learned
So I leave this two-month experiment a little poorer, but hopefully wiser. I bought shares of Travelzoo before the drop, but I am still confident in its business and continue to hold the shares. The importance of a years-long investing horizon has been powerfully reinforced, and I still think there are deals to be found among these stocks. Now, however, I'll tread even more carefully among the heavily shorted ranks.

If you'd like more ideas for investing your hard-earned cash, I'm willing to offer you a special free report: "The Only Stock You Need To Profit From the NEW Technology Revolution." Inside, you'll find out about another innovative company with a breakthrough technology that is changing the face of business. It's yours today, absolutely free!

At the time this article was published Fool contributor Brian Stoffel believes that learning from mistakes is the most important thing any investor can do. He owns shares of Travelzoo and SodaStream. The Motley Fool owns shares of Ebix. Motley Fool newsletter services have recommended buying shares of SodaStream International, Green Mountain Coffee Roasters, First Solar, Ebix, and Travelzoo, creating a lurking gator position in Green Mountain Coffee Roasters and shorting Green Mountain Coffee Roasters. 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.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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