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Are fallen stars like Apple a buy?

Here's a look at five formerly high-flying stocks that have entered bear-market territory – and whether they are worth buying now.

  • By Daren Fonda,
  • Fidelity Interactive Content Services
  • – 11/19/2012
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What do Apple, Chipotle and Netflix have in common? They're all high-growth superstars that have tumbled more than 20% from their 52-week highs, leaving them squarely in bear market territory.

What should you do if you own one of these fallen angels? And if you don't, is now a good time to buy?

Before you decide, you need to evaluate why the stock has dropped and whether the company can get back on track. But other factors in the market may be at work too.

For one thing, price momentum usually continues for some time before slowing and reversing course. "When things turn for the worse with a growth stock, it can be a long downward path," says Mark Oelschlager, portfolio manager of the Pin Oak Equity Fund (POGSX).

That can be especially true for high-growth stocks, companies expected to grow at above-average rates relative to the market or their industry. Investors pay a premium for these stocks, bidding up their price/earnings ratios to lofty levels.

A quarterly earnings report that falls short of Wall Street's forecasts may send these stocks crashing, and if investors start to sense that growth or profitability won't recover soon, the stock may keep sinking.

High-growth stocks are also particularly vulnerable because they appeal to fast-moving hedge fund managers and other aggressive investors who often bail if the stock drops below certain price thresholds.

Indeed, their stock prices may drop simply because their base of shareholders starts changing from aggressive investors to those with more of a "value" mindset. As that shift happens the stock may enter a "never-never land" where both types of investors shun it, says Peter Tuz, co-manager of the Chase Growth Fund (CHASX).

When good stocks really are on sale

Still, there are situations where a solid and growing business has been oversold. A stock that has posted big gains may fall because investors are taking profits. Indeed, with capital gains tax rates likely to increase next year, investors may be selling their winners to lock in lower rates before year-end.

How to separate strong businesses from broken growth stories is the tricky part, of course. But there are a few basic guidelines that many investing pros follow.

If you own the stock, revisit your original investment thesis to be sure it's still intact, says Edward Painvin, a portfolio manager with Chase Investment Counsel, in Charlottesville, Va.

Painvin says he typically identifies three or four "key drivers" of a stock's outperformance and checks to see if they are still in place. He might look at whether the company is still gaining market share, for example, or whether profits are weakening from heightened competition. "When you get a 'driver violation' that means you've got the thesis wrong and it's time to sell," he says.

Remember that even a stock that's tumbled and starts to appear inexpensive can actually be quite expensive if its growth rate isn't likely to recover.

Investors are willing to pay more for companies that operate in attractive industries with few competitors, long-term growth and earnings visibility, says Matthew Schuldt, manager of the Fidelity Select Computers Portfolio (FDCPX). But when those things start to fade, the stock can head into an inexorable fall.

In those cases, he says, "Valuation is a slippery slope. You have to separate price from value."

With that in mind, here's a look at five fallen angels — and what some investment pros recommend for each stock.

Apple

  • Ticker: AAPL
  • Forward price/earnings ratio: 11
  • Dividend yield: 2%

Apple's iPhones haven't just given the company 34% of the U.S. smartphone market and 17% of the world market; they've changed the way millions of people communicate and have become cultural icons in the process.

That kind of growth has been very compelling: The stock has returned more than 300% since the first iPhone went on sale in June 2007 – and Apple's latest products continue to show strength. The iPhone 5 shattered Apple sales records in its first week on the market, and other Apple products are flying off the shelves. Yet the stock has pulled back about 23% from its all-time high of $705 a share and recently traded at six-month lows.

Investors are worried that Apple's manufacturers in China aren't keeping up with demand for new products. Other concerns include lower profits on each new iPad and iPhone sold and uncertainty about Apple's product lineup in 2014 and beyond.

Yet Apple's stock may already reflect these concerns, says Painvin, who owns the shares in the Chase Growth Fund (CHASX). Apple trades at just 11 times forward earnings, he notes, while analysts expect earnings to grow 13% in its 2013 fiscal year. If you strip out its $121 billion in cash, the stock trades at less than eight times earnings — a roughly 40% discount to the broad market's P/E of 13.4.

The iPhone is expected to go on sale in China by the end of this year, he points out, and it should rack up strong sales in part because it's one of the few smartphones that can take full advantage of China Mobile's (CHL) next-generation network. Moreover, Apple's integrated suite of products and services create a "sticky" ecosystem that gives the company a strong competitive advantage.

Judging by the deep discount in Apple's stock, the market seems skeptical that Apple can hold its lead over rivals like Microsoft (MSFT) and Google (GOOG), especially without Steve Jobs to conjure up the next hit product. But Apple has a good head start, and even if earnings growth slows from the current rate, Painvin believes the stock has "significant upside" from here.

Chipotle Mexican Grill

  • Ticker: CMG
  • Forward price/earnings ratio: 25
  • Dividend yield: No dividend

For many years Chipotle, the fast-food chain that sells burritos and other tasty items, was a sizzling stock with a rapidly growing store base and earnings. From its November 2008 lows around $40 a share, the stock soared more than 1,000% to $440 a share in April 2012 — outperforming even Apple.

Since then, Chipotle has plunged around 40% to $262 a share. Profit margins have weakened, in part due to higher food costs and operating expenses. While the company plans to open 165 to 180 new restaurants next year, adding to the 1,350 outlets already open, it's facing stiffer competition from rivals like Taco Bell (YUM), which recently launched a new "gourmet" menu of premium items in a bid to lure customers from Chipotle.

Many Wall Street analysts downgraded the stock after the company missed third-quarter estimates. And analysts expect earnings to grow 17% next year, down from 30.5% in 2012.

Despite the stock's decline, Chipotle isn't particularly cheap, trading at 25 times estimated 2013 earnings, almost double the market's P/E ratio. Yet the stock has always traded at a premium to the market, and some analysts argue the valuation is justified, based on the company's strong growth potential.

Chipotle is considering raising menu prices in 2013, which could help lift profit margins without impacting sales, Miller Tabak analyst Stephen Anderson wrote in a recent note. Food costs may be a bit lower next year as well, helping keep expenses in check.

And the company may finally be ready to ramp up growth of its new Asian-themed restaurant called ShopHouse. The restaurant is likely to appeal to young, urban consumers, he notes, and Anderson figures the company could open 300 to 400 ShopHouse locations in the next 10 years in urban and campus locations.

His bottom line: While the "fear factor" of slower growth remains in the stock, "we think it will be overcome."

Netflix

  • Ticker: NFLX
  • Forward price/earnings ratio: 160
  • Dividend yield: No dividend

How addicted are Netflix subscribers to their streaming movies and TV shows? According to research firm Sandvine, Netflix accounts for a third of Internet video downloading during peak viewing hours — trouncing competitors like Amazon.com (AMZN), which has 1.8% of downstream video traffic.

Yet while Netflix may be the king of video streaming, its dominion is under attack. Rival services from Wal-Mart Stores (WMT) and Amazon.com, while still small, are starting to gain traction. Netflix's content costs are climbing while subscriber growth has slowed. And profits have plunged as Netflix has plowed money into expanding internationally and boosting its content lineup.

All this has pummeled the stock, which has tumbled 40% from its 52-week high. Only six of 35 Wall Street analysts now rate it a buy or strong buy.

Netflix has defied reports of its death in the past, and some savvy investors see value in the stock. Most notably, activist investor Carl Icahn bought nearly 10% of the company, dubbing Netflix the "greatest platform" for streaming video.

Cantor Fitzgerald analyst Kip Paulson also sees upside in the stock. Even with increasing competition, the company should continue to benefit from a shift to Internet-based viewing, he wrote in a recent note. Cable companies like Comcast (CMCSA) have reported two straight quarters of subscriber losses and if the trend continues, companies like Netflix that offer alternative services could benefit.

Yet at around $80 a share the stock trades at a stratospheric 160 times estimated 2013 earnings — too rich for its expected profit growth, according to some investing pros. Content providers have the upper hand in pricing, notes Tim Cunningham, co-manager of the Thornburg Core Growth Fund (TCGCX). Even if growth picks up, Netflix's profits are likely to come under pressure as content costs increase.

His take? "We've avoided it."

BJ's Restaurants

  • Ticker: BJRI
  • Forward price/earnings ratio: 25
  • Dividend yield: No dividend

Restaurant chain BJ's serves up artisan-style pizza and craft beers in a brewhouse atmosphere. It's been a business success for years, and the stock has soared more than 433% from early 2009 to mid-2012.

Since then, however, BJ's stock has slumped. The company missed third-quarter earnings estimates and reported lower sales growth at outlets open at least a year. The stock has tumbled 37% from its 52-week high.

Yet some analysts figure BJ's still has strong growth ahead. The company runs 130 restaurants in 15 states and could expand to 425 restaurants in the coming years, according to Sterne Agee analyst Lynne Collier. BJ's has instituted a loyalty program and recently upgraded its menu to help boost sales in 2013. And profit margins could improve as some food inflation subsides.

With a price/earnings ratio of 25, the stock trades at a steep premium to the market. Yet as a high-growth stock BJ's has long commanded a premium multiple, and it now trades below its three-year average P/E of 35.5, notes Barclays analyst Jeffrey Bernstein.

Growth may pick up if the economy continues to improve. And with its focus on low-cost pizza and beer, the company has "good pricing and margins," says Cunningham, who owns shares in the Thornburg Core Growth Fund (TCGCX).

Bed Bath & Beyond

  • Ticker: BBBY
  • Forward price/earnings ratio: 11
  • Dividend yield: No dividend

Many companies tied to the nascent housing recovery have rallied during the past six months. But home furnishings retailer Bed Bath & Beyond has been left behind, slumping 20% since mid-May and trading near its 52-week low around $57 a share.

The company made two acquisitions this year — home-goods retailer Cost Plus and linens distributor Linen Holdings — for more than $650 million combined. While those acquisitions may eventually pay off for shareholders, they've pressured earnings. Bed Bath & Beyond's net income fell 2.2% in its fiscal second quarter — its first decline in quarterly profits in more than three years. And sales growth at stores open a year or more slowed to 3.5%, from 5.6% a year earlier.

Looking ahead, some analysts see growth picking up. The company plans to roll out more food items, adding a "tailwind" to sales starting in 2013, according to analyst David Magee with SunTrust Robinson Humphrey. The Cost Plus stores should help increase earnings, he adds.

And despite growing competition from online giants such as Amazon.com, Bed Bath & Beyond remains a "best-in-class" specialty retailer, according to Raymond James analyst Budd Bugatch, who has a "strong buy" rating on the stock.

The housing recovery could be another tailwind.

"When people buy homes they buy lots of new furnishings," says Jeanie Wyatt, chief investment officer of South Texas Money Management, who recommends the stock for her clients. The housing rebound gives her more confidence in the company's earnings guidance, she adds. And the stock looks reasonably priced: Analysts expect earnings to grow 11% in fiscal 2014 and the shares trade at 11 times expected earnings, in line with profit growth.

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