Don't Get Burned by These Firecracker Stocks

Fireworks are a beautiful sight from afar. But if you get too close, you're going to end up burned. This can be the case with some stocks, too. Their short-term performance might be a sight to behold, but becoming a long-term investor in these companies after a runup is only going to leave a hole in your portfolio.

Even after the breather the market took in the second quarter of 2010, stocks have come a long way from their 2009 lows, and many have bucked the trend and kept rising as the broader market fell. Some of these rises were justified by the improving conditions of the business. Rising corporate profitability, better access to credit, and a rosier business outlook mean that some stocks are actually worth more now than they were at the start of the year.

But the shares of some companies have risen beyond what business fundamentals justify. Investors seem to be overly excited by a new product or service, or they are being too optimistic about the strength of the recovery. This problem can be particularly acute among companies with a very wide range of potential outcomes. People sometimes fixate on the upside of a firm while discounting the possibility that something could go terribly wrong.

Buying into these stocks can be risky business. Much of the upside has likely already been realized, and there is a chance of a sharp price decline if investors suddenly start focusing on the downside potential. To find some of these stocks to avoid right now, we used our  Premium Stock Screener. We screened for stocks that look pricey right now (1- or 2-star rated), have a broad range of potential outcomes (fair value uncertainty rating of very high), and have done relatively well in 2010 (year-to-date total return greater than that of the S&P 500). You can run the screen for yourself  here. Below are three stocks that passed the screen:

 Opentable 
Price/Fair Value Estimate: 2.3, YTD Total Return: 63%
From the  Premium Analyst Report:
With restaurants increasingly embracing technology to drive traffic and cut costs, we find Opentable's automated reservation platform compelling. We believe Opentable has developed a narrow economic moat, given the high switching costs for restaurants, burgeoning network effect, unique product features, and the lack of meaningful competition.

With greater uncertainty in the global economy, consumers have increasingly traded down from reservation-taking restaurants or simply prepared meals at home. Reservations seated by restaurants decreased materially during 2009, and we expect only a modest recovery in 2010. Additionally, economic challenges could increase customer churn as more restaurants cease operations. International expansion also carries its own risks, including development costs and better-established competition.

 Cardiome Pharma 
Price/Fair Value Estimate: 1.6, YTD Total Return: 79%
From the  Premium Analyst Report:
After three years spent dealing with the Food and Drug Administration over its new drug application for Kynapid, Cardiome Pharma faces one more hurdle before it can gain approval for its first product. The firm will need to conduct an additional study. If the trial succeeds and Kynapid wins approval, we still think Cardiome needs to look to the oral version in order to become a profitable firm.

The FDA voiced safety concerns about the subset of the population with heart failure; if the firm cannot prove Kynapid's safety in a healthier population with an additional trial, the FDA could reject the drug and the firm's value would plummet. Even if Kynapid does receive approval, Cardiome could face a tough battle gaining market share due to strong competition in the cardiac space.

 SuccessFactors 
Price/Fair Value Estimate: 1.8, YTD Total Return: 23%
From the  Premium Analyst Report:
If profits measure the success of businesses, then SuccessFactors has not been all that successful. The firm provides a software service that helps its customers streamline and organize human-resources-related administrative activities. This is a relatively untapped market, and the firm has taken huge losses to expand its market share. However, management improved profitability in fiscal 2009, and the firm is poised to post its first-ever profit.

The major risk facing SuccessFactors is its ability to turn impressive internal revenue growth into profits. Operating margins have been deeply negative, and if the firm can not improve this situation, then its viability as a going concern could be jeopardized. The weak economy is also a major concern. The rate of new customer acquisitions and retention could be seriously tested during this recessionary period.

The ability to raise funds will be a major obstacle as the capital-raising markets have dried up. We believe these trends will continue over the near term until businesses gain more confidence and start to spend on new and delayed projects. The firm also faces potential competition from other HR outsourcing and software firms, which have the capability of developing similar products to SuccessFactors'.

Data as of July 2, 2010.