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Globe Investor Scooping up ‘fallen angel’ stocks can be heaven or hell

A scene from ‘Orange is the New Black,’ which airs on Netflix, which has endured a couple of big dips on the stock market.

Barbara Nitke/Netflix

It's human nature. Everyone wants a piece of something when it's the hot new phenomenon. But when negative aspects pop up, we tend to jump off the bandwagon and want no part of it.

The same thing applies to investing. Hot new companies with soaring stock prices get attention from media and investors. But when something bad happens, and the company's stock price falls, we often forget all about it.

But is this how it should be? Can investing in what might be called "fallen angels" be a valid investing strategy?

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In some cases, buying a hot stock after it has been knocked back has rewarded investors. Some companies have been so successful it's easy to forget that they were once completely out of favour.

Apple Inc. was instrumental in the creation and popularization of the home computer. It was also a successful investment in the years after its initial public offering in 1980. But by the summer of 2006 growth had stalled, even with the rise of its music player, iPod. Its stock stalled, too.

But the iPhone was just around the corner. Its share price is now more than 10 times higher, and Apple has become the most valuable company in the world.

Netflix Inc. shares have had two major drops. In the fall of 2011 its share price took a dive on concerns about the company's transition from sending DVDs in the mail to streaming online. After recovering, the stock was hit again in the summer of 2012, this time on worries about slowing subscriber growth. Just like with Apple, its shares have increased more than tenfold since that dip.

Facebook Inc.'s situation is a little different. Most of its hype occurred in the leadup to its IPO in May of 2012. By the time it actually began trading, investor interest had cooled. Its stock price fell to half its initial trading price. Most observers turned their attention away.

But the company has continued to build its business, including adding new applications such as Instagram. Its shares have been on a steady upward climb ever since, recently topping $100.

"A 'posthype' stock with an underlying solid business model that falls back to Earth can be a wonderful buying opportunity," says Teal Linde, president and founder of Linde Equity, a Vancouver-based investment advisory service. "The key is to separate the posthype stocks of substance from those full of just hot air. It depends on whether the hot stock is driven by substance or sizzle."

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Mr. Linde points to examples that show both extremes. The first is Priceline.com LLC, the online discount travel-booking service. He notes it was one of the hottest stocks of the 2000 "tech bubble," but by 2003 its shares had plummeted, falling by more than 90 per cent from their peak. "But the company had substance," he says.

In the summer of 2008, Mr. Linde bought Priceline for his clients at $132 a share. It has proven to be a tremendously good move. Unlike many of the dot-com companies, its business model was always solid, its revenue and earnings have continued to grow, and Priceline shares have soared to an eye-popping $1,350 apiece.

But some hot stocks have fallen back to earth and never recovered. Perhaps the most notorious Canadian example is Nortel Networks Corp. Mr. Linde says he researched the sector in the 1990s and was surprised when Nortel acquired a company he thought was "lousy" – Bay Networks.

He notes that every time Nortel fell in price, investors mistakenly bought more. The company eventually went bankrupt. "Nortel was a hot stock that was all hype and no substance," he says.

Figuring out whether to invest in a fallen angel comes down to how well you do your homework, says Greg Newman, an associate portfolio manager and senior wealth adviser at ScotiaMcleod in Toronto

He says investing in posthype stocks can be a good strategy, but the company's fundamentals must be strong.

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He also notes that investors typically have to wait for these former market darlings to be "washed out" technically as well. By this he means that enough short-term investors must give up on the stock and sell it. This can take several years especially if the stock is owned by a lot of unsophisticated investors who, unlike professional traders, may take too long to sell.

"These names often become so hated that they can eventually be a wonderful opportunity for the patient," he says.

There is a new candidate for fallen-angel status. Valeant Pharmaceuticals International Inc. has been one of the hottest stocks on Canadian markets, even briefly becoming the most highly valued company listed in this country. But its share price has plummeted in recent weeks as its accounting and business practices came under scrutiny.

Mr. Newman says the risk is just too great to recommend it. "Unless I feel comfortable that there is no wrongdoing, I always stay away," he says. "Aggressiveness is one thing, improper activity is obviously totally different."

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