Look Out Below!

I wrote about ten-baggers last year.  Ten-baggers are stocks that increase in value ten-fold and create great wealth for you along the way.

Now the flip side.  Stocks that drop like a rock and destroy wealth in the process.  Look out below!

Even with great investment returns it is difficult to overcome the loss of your capital.  Therefore, you should always be concerned first with how secure your original capital is before considering how much you are going to make on top of it.  The noted humorist Will Rogers probably said it best when he quipped,

"I'm more concerned with the return of my money than the return on my money."

Look at the chart below and you can see how difficult it can be to recover from a bad investment.

% of Investment Lost     % Gain Needed On Next Investment To Break Even
          10%                                                     11%
          20%                                                     25%
          25%                                                     33%
          50%                                                   100%
          75%                                                   300%

The mathematics above should lead you to follow a rule of cutting your losses early when you invest.  Losing 10% of your money on an investment only requires you to make 11% on your next investment to get your money back.  This is generally achievable in many circumstances.  However, if that loss continues and you are down 20% , it is going to take a 25% gain to make yourself whole.  That starts to become a real stretch with a much different risk/return profile.  A 50% loss requires you to find another investment that will double to get you even.  Good luck!  You are going to need it.  In fact, only one stock in the S&P 500 had a return in excess of 100% for 2011.  Cabot Oil & Gas led this year's list of top performing stocks with a 101% total return for the year.

What were the big-name stocks that were on the other side of the ledger in 2011?  These are three examples of where you needed to "Look Out Below!".

Eastman Kodak
Kodak lost 88% of its value for the year.  It closed 2011 at .65 per share. That's right, 65 cents!  In 1997, Kodak's stock was trading at $95 per share.  In the mid-1970's, Kodak had a 90% market share of photographic film sales in the United States.  Digital cameras have killed Kodak's business.  It has not made a profit since 2007.  It has spent the last few years trying to generate revenues from its vast portfolio of patents.  This company is probably past the point of no return. Bankruptcy is undoubtedly in its future.

Research in Motion
RIM is the Canadian company that is famous for its BlackBerry product.  RIM's stock price declined 75% during the year.  2 years ago the stock traded at almost $86 per share and it ended 2011 at $14.50.  The  iPhone has hurt RIM but the iPad has been far more devastating.  RIM's Playbook tablet has been a disaster.  RIM recently took a $500 billion charge for excess inventory of the Playbook.

RIM is a stock that could come back.  It is currently trading at about 75% of book value.  The current price is also only about .37 times total sales.  You don't find that often.  It has no debt and $2.50 of cash per share.  They have taken a beating but companies with this type of balance sheet can recover if they don't make more mistakes.  They still have 75 million subscribers worldwide but they need to be able to match up with the iPhone or they will start to lose customers.  Its next operating system, the BlackBerry 10, will be important to RIM.  They cannot afford another clunker in the competitive mobile wireless space. The future of this company might be as an acquisition target.  This stock might be a sleeper for a comeback in 2012 if the BlackBerry 10 meets expectations.  It not, look out below.

Netflix
Netflix paid the price for one of the biggest customer faux-paus of the year.  It announced on September 18, 2011 that it was going to split its DVD and Streaming services and customers would be charged separately with the DVD rental business becoming a separate company.  In the wake of the loss of almost 1 million subscribers, on October 10, 2011 the company reversed course and cancelled the planned separation.

Netflix stock lost 60% of its value for 2011 dropping to $69.30 at year end from $175 per share to start the year.  However, it lost 77% of its value from July, 2011 to the end of the year.  The stock had gotten as high as $300 per share in July, 2011 shortly before management decided they had ideas that could make even more money for its shareholders.  Bad move.

Netflix is another stock that may be a comeback candidate for 2012.   However, its long term prospects are going to depend on how well it can take advantage of its brand position with streaming content and be able to convince content providers that its flat rate pricing model is the way to go.  Beware Apple, Amazon and Google invading its space.  It might also be an acquisition candidate by someone in 2012.

Disruption
We often hear that technology is a disruptive force.  There was certainly disruption in the stock prices of all three of these companies in 2011.  Technology was an important factor in the success of these companies. These companies all were built around improved technology. They are now threatened by it, or are being disrupted by it, right now.  In the end, technology will not make or break these companies.  Management will.  The jury appears to already be in on Kodak.  Its management did not adapt to new technology and it will die in its present form.  The future of RIM and Netflix will ultimately depend on how their management's manage technology and its impact on their companies.  2011 was a good lesson on how brutal the market can be, even with big names and well known brands.

My advice for the New Year is simple.  Keep your head up in 2012 and always look out below when you invest.  Think about the upside in any investment but make sure you know how far the basement floor is below you.