Alcatel-Lucent (NYSE:ALU), Apple (NASDAQ:AAPL), Chipotle (NYSE:CMG), and Netflix (NASDAQ:NFLX) are in different lines of business. But they have two things in common: Their stocks were, and some still are, flying high on Wall Street. The problem, however, is that high-flying stocks do not stay that way forever. In almost every case, there comes a a time when these stocks descend to earth, creating a great deal of loss to investors who joined the game late.
When is that time? What are the warning signs?
Some analysts look at profit margins. Others look at a leadership/management shift. A third group looks at technical. I focus on one metric all highflyers share: sales growth. Once sales growth slows down, the wings of highflyers are clipped, the momentum shifts, and the company drops from everyone's radar.
High-flying Internet search company Yahoo (NASDAQ:YHOO), for instance, was ranked No. 1 in Fortune's 2005 high-growth companies list, as its revenues grew by leaps and bounds at that time. But as growth faded in subsequent years, the company disappeared from the list. BlackBerry (NASDAQ:BBRY) and five others included in the same list around that time displayed a similar pattern.
In some cases the pause is temporary and the company resumes growth, drawing renewed attention by the usual crowd. Apple is a case in point. In the early 1980s, the company's growth stalled after the departure of its founder Steve Jobs, but it resumed and regained momentum after his return in 1996. Corning's (NYSE:GLW) growth paused several times in its 160-year history, but each time it eventually resumed -- helping the company survive and thrive, churning out products that changed the world such as the fiber-optic cable (the backbone of the Internet) and flat glass, which revolutionized TV sets. In the late 1990s, IBM's (NYSE:IBM) growth resumed after a brief pause a few years earlier, with its stock reaching new highs in subsequent years.
In other cases, the slowdown in economic growth is permanent but not fatal. That was the case with Xerox (NYSE:XRX) in the late 1990s and, in the early 2000s, Cisco Systems (NASDAQ:CSCO), JDS Uniphase (NASDAQ:JDSU), Ciena Corporation (NYSE:CIEN), and Alcatel-Lucent. All of these have yet to return to the old glory days. In a third scenario, the slowdown in growth is permanent and fatal. This has been true for Enron, Kmart, Eastman Kodak, Global Crossing,and Nortel Networks, all of which ended in bankruptcy.
Simply put: Once growth fades, momentum rarely returns.
To test this hypothesis, we took a close look at seven stocks included in Fortune's high-growth company list for the years 2005 and 2006 but eventually were removed. In all cases, a decline in corporate growth was followed by a sharp decline in the stock price, with two companies eventually going under. There was one notable exception -- Netflix. The company reached new highs, though its revenue growth never re-accelerated. What can explain this anomaly?
What Happens to Momentum as Growth Fades? Fortune's 7 Former Fastest-Growing Companies
Fortune's Former Rank
Stock Price When Last on the List
Stock Price in 2012
Chesapeake Energy (NYSE:CHK)
Investors seemed to focus on subscription growth rather than revenue growth, still hyped by the company's prospects. We don't believe the prospects for Netflix are that bright, as we discussed in a previous article. That's why investors should be careful trading the stock on both sides of the market.
The bottom line: High-flying stocks are good long-term bets as long as sales growth accelerates, and bad bets once sales growth deaccelerates. That's the time to sell them.