By Guest Columnist Chris Fernandez of PeakStocks.com

It’s been about two months now since I advocated selling your full position, if you had one, in SoundBite Communications (SDBT), a provider of on-demand customer contact solutions.

In those couple of months, I’ve had time to reflect upon what went wrong with my investment thesis in SoundBite, what I learned from the debacle, and how I can apply those lessons going forward.

My hope is that by sharing these insights with you, you can also strengthen your investing parameters and better understand what goes into my criteria for selecting companies for inclusion into the PeakStocks.com portfolio.
SoundBite Communications is a provider of on-demand automated voice messaging, or AVM, solutions that are delivered through a software-as-a-service, or SaaS, model.

When I bought it, SoundBite was a cheap company, with great growth prospects in a small niche field. It had recently come public, and I had watched its stock price steadily decline, in spite of its seemingly impressive and improving fundamentals and wonderful business model.

So I did some digging around.

What I found out should have given me pause, but I was too focused and blinded by the “cheap” valuation and the fact that in its only quarter as a public company, SoundBite beat and raised guidance to such a degree as to seem like an unbelievably cheap stock compared with any comparables available at the time.

There was trouble in the water, however, and while difficult to spot, I did have warning signals going off inside my head that I should have listened to. Here are the reasons my SoundBite investment thesis was wrong and the warning signs I should have paid more attention to:

1. I didn’t understand the industry well enough.

The AVM market is not what I would consider a complex industry to understand. Pretty much every business on earth has some sort of voicemail system, message tree or other system for routing customer calls and for staying in contact with them via direct dialers or other systems.

What I didn’t realize was that this industry was becoming largely commoditized and that regardless of the offerings that SoundBite staked its claim to, when it is all said and done, the end game is always about saving money. When companies wish to contact their customers for debt collection, payment reminders, surveys, security alerts on their accounts and so on, they are looking for the most cost-comprehensive solution, not necessarily the most comprehensive solution.
Further, the majority of SoundBite’s revenues were derived from the collections industry (84% in 2008), and SoundBite’s management team mistakenly assured investors that in a declining economy, its business would thrive because that’s when debt collectors get more charged off debt to collect. That did not prove true.

Instead, people were losing their jobs and homes, and there was a lack of credit available. Most folks were having trouble paying day-to-day bills, let alone even thinking about paying old debt that they could not afford to pay. As a result, SoundBite’s revenues, profit, margins and guidance, which had seemed so unbelievable just a few months back, tumbled, and along with them the stock price and my investment thesis.
It’s funny how it turns out that there really aren’t any “recession-proof” businesses, or businesses that do better when times are bad. Debt-collecting, it turns out, is no exception.

Lesson learned: Do more homework on an industry that you don’t understand. Don’t ever take management’s word for it that things are going to be fine, and that a recessionary market is going to be good for business, even when it appears that the argument makes intellectual sense.

2. Miss guidance once, shame on you. Miss guidance twice, shame on me.

This one isn’t as cut and dry as it appears. I sincerely believe that SoundBite’s management team was as caught off -guard by the decline in its industry as much as we were. That being said, management took guidance down heavily after first-quarter 2008 earnings.

At the time, in conversations with the management team, I was told that it took guidance down so heavily as a result of wanting to control expectations and put in a natural buffer just in case things got worse and because it never wanted to have to lower guidance again.
Oops.
When SoundBite reported second-quarter 2008 earnings, expectations were not just cut again but slashed, with growth targets going from the 35%-to-40% range to just breakeven-to-10% sales growth!

In retrospect, I should have known that if a company has to restate its expectations to such a high degree the first time around, odds are it's going to do it again, and it’s not going to be pleasant, especially if that company just came public and has no track record to speak of.

The good news was that as a result of SoundBite’s first-quarter earnings miss and guidance reductions, the stock really didn’t decline much more when it lowered its guidance after its second-quarter earnings release for the rest of this year and for the next few years, because the stock was already trading for around cash value.

My theory was that with the stock already off about 60% from where I cost-averaged in, an earnings miss or forward guidance revision wasn’t going to affect the stock price as a percentage of my loss by any great margin.
Lesson learned: Ignore deteriorating fundamentals at your own peril. When a certain industry, sector or company shows initial weakness that catches both management and Wall Street off-guard to such a degree, it would be unwise to ignore that deteriorating state from an investment perspective. In addition, without a prolonged track record of success, early trouble with a newly minted public company should set off extreme warning signals.

3. Management was not passionate about their business.

This is a bigger factor than you might imagine. Whenever I spoke to management on the phone or listened to its conference calls, I never got the sense that it was passionate about its business and what it was doing. It was no secret that the CEO/CFO and other members of the management team were brought in to replace founding members, but this is one warning that is more subtle and less obvious than other investing factors.

Lesson learned: Passionate management is a must. Those who work because they choose to, not because they have to, can lead and inspire others and see opportunity where no one else has before. Passionate and great leaders of companies would work for free. If you ignore this tenet, you are treading on hot coals hoping not to get your feet burnt.

4. Founding members were missing in the company's management team.

This is similar to the lesson above. It is more than a little disconcerting to look around at the management team in place at a company and not see anyone who founded it. This isn’t always a 100% requirement, as founders leave for one reason or another, but with a company as small and as new as SoundBite was, I believe this was another warning sign.

Lesson learned: When dealing with small- and micro-cap stocks, an original founder with a large personal stake in the company who is passionate about his or her business is a 100% must-have. There can be no compromise when entrusting your investment in a company that has yet to prove itself with a management team that was merely brought in to take the company public, with no other personal interest to see it succeed.

5. Management couldn’t explain its competitive advantages.

I recall speaking to management and asking what it believed the company's competitive advantages were. After management bumbled about for a few minutes with rhetoric and double-speak, I got something that resembled a competitive advantage.

Looking back on it now, and further analyzing my investment thesis, it is clear that while SoundBite may have thought it had some sort of competitive advantage, all it really had was a pig dressed up with lipstick on it.

The AVM market is intensely competitive and basically serves the needs of first- and third-party customers to fulfill debt collection and early-stage bill payment servicing. Sure, there are a myriad of other uses, such as keeping in contact with customers and sending them special offers via SoundBite’s new text messaging offerings, but when it all comes down to it, companies are looking to save money and collect more of the money they are owed.

In the end, it matters more if a company can do that cheaply than if it has an extra layer of bells and whistles that it claims give it a competitive advantage. What’s more, when you talk to management and it has trouble explaining c lear competitive advantages to you, there’s something wrong there.

Lesson learned: When researching a company, make absolutely certain that you understand that company’s competitive advantages in detail. Furthermore, analyzing whether those advantages are rock-solid moats around the business or whether they are merely up-selling features on a commoditized product is crucial to understanding the full investment thesis and to backing out of a potential dead-on-arrival investment.

While no competitive advantage lasts forever, if the company you are thinking of investing in doesn’t continue to execute and differentiate itself for the timeframe of your investment thesis, then you can bet that any advantage that it did have will be long gone before your thesis pays off.

6. Commoditized industry becomes a feature instead of a business.

This was a slight concern of mine going in, but I should have been more aware of the declining market and the fact that most companies in this industry want to save money and collect money, not spend more money to collect less money.

It is a natural progression with most industries that competition drives down prices and hurts the bottom line unless a company has a clear competitive advantage, which SoundBite did not -- at least not to warrant the premium pricing structure to which it had become accustomed. As more and more companies get into the AVM business, these offerings are going to become a feature set of other product offerings instead of standalone products.

Think of this as akin to TiVo (TIVO) and its DVR service, which is known now as a feature (the ability to record shows and pause live TV) rather than a standalone business of selling set-top boxes with cool features.

The same thing was happening, or was going to happen, to SoundBite and its technology. Eventually, the services that SoundBite offered would be either offered by many other companies or offered as standard features by companies that already dealt with the AVM market, such as Avaya and Premier Global Services (PGI).

Lesson learned: When looking at a niche technology and a standalone company within that niche, make sure that that technology is a sustainable long term as a business, not just a product. While it is sometimes difficult to tell, if I would have combined this observation with the fact that SoundBite had no real competitive advantages, I might have discerned that it would only be a matter of time before SoundBite would find itself in the exact position that it is in today.

7. I didn't listen to my instincts.

Instincts are merely past experiences resonating within your subconscious. You can ignore them at your own peril, and unfortunately, I did.

Through my various conversations with management and the due diligence that I performed on SoundBite from top to bottom, I never got a “gut” instinct that this was an amazing company that I needed to be invested in right now. Over time, I convinced myself through my research and through the ridiculously cheap valuation of the stock at the time that there was something here that Wall Street was missing.

My years of experience and travails dealing with these sorts of companies was already resonating deep within me telling me that something was amiss, and to stay away. I should have listened.

Lesson learned: Don’t discount your instincts. It’s better to be wrong when you go with your gut than to be wrong when you ignore it. Of course, you have to make sure that your gut is reading the right signals and that your instinct is based on years of experience in dealing with what you are about to make a decision on.

Bottom Line: Learn and Move On

I hope that by passing on some of the lessons that I learned when looking back on my mistake with regards to investing in SoundBite, you can glean some information that will help you when analyzing and making your own investment decisions.

In this business, you are apt to be wrong about the same amount of times you are right. If you manage to pick six times out of 10 correctly, I guarantee that you will be a success.

The devil, however, is in the details. With my diligence and research and the expertise I have gained over a decade of analyzing and researching stocks, these lessons serve as valuable reminders that no matter how far along in the game you are, you always can learn something new. And like it or not, you will continue to learn more from your failures than you ever will from your successes.

Know What You Own: SoundBite operates in the telecommunications industry. Some of the other stocks in this space include AT&T (T), China Mobile (CHL), BCE (BCE) and Level 3 Communications (LVLT). These stocks recently closed at, respectively, $26.86, down 4.5%; $46.45, down 4%; $31, down 4%; and $2.01, down 11.1%. For more on the value of knowing what you own, visit TheStreet.com's Investing A-to-Z section.

Caution: SoundBite trades with very high bid/ask spreads. Learn how to protect yourself from getting screwed by the market makers.

Chris Fernandez is the founder and CEO of PeakStocks.com, a Web site dedicated to the micro-cap and small-cap stock universe. A version of this article was originally published here.

Posted on Oct. 6, 2008