plunge in the last two months of the summer was, in hindsight, a
clear overreaction. But the subsequent sharp rally may also be a
false signal. Simply put, the
remains unhealthy, Washington threatens to scare investors with an
ongoing inability to agree on anything, and Italy -- a country that
is 10 times larger than Greece -- looks like the latest emerging
Regardless, the playbook hasn't changed: Buy inexpensive stocks
while selling (or even shorting)
stocks. In a fresh market rout, the inexpensive stocks are likely
to hold up better. Those overvalued stocks? Well, as we saw with
, investors can punish a high P/E stock that stumbles.
Surprisingly, there are still many pricey stocks in the market,
despite all the turmoil of 2011. In fact, there are 19 stocks in
the S&P 500 that trade for at least 25 times projected
(which in most cases is 2012) profits. (I'm not counting real-state
investment trusts and energy sector plays, as they are often more
about the assets and
To be sure, some of these richly-valued names can stay that way for
some time. Anyone looking to short
simply because management dampens near-term profits by investing in
long-term growth has always lost that bet. (Although a triple-digit
forward multiple hardly inspires notions of buying either.)
Yet for some stocks, it may only be a matter of time before a high
price-to-earnings (P/E) ratio comes back to bite. For example, I
suggested shorting software vendor
back in June
, and though the stock has since shed about $10 to drop to a recent
$131, it still looks very expensive. In my view, analysts
overestimate the company's ability to keep growing and
underestimate budding competition. For example,
recently-proposed $1.5 billion
RightNow Technologies (Nasdaq:
should create formidable competition for Salesforce.com in the
customer relationship management business.
Beyond looming competition, it's an unusual
practice that may trip up this stock. Salesforce.com expends a
significant amount of money trying to snag new customers. Because
those new customers sign up for monthly subscribed access to its
software, Salesforce's accountants believe sales commissions
deserve to be capitalized as long-lived assets, rather than the
more typical expense accounting that most other firms employ when
it comes to sales commissions. By one estimate, this capitalization
rather than expensing of sales expenses has overinflated
by 40%. We're talking about a company that already trades for more
than 70 times fiscal (January) 2013 earnings, so the real multiple
may be closer to 100.
Rising competition and questionable accounting will again come
under scrutiny when Salesforce reports fiscal (October)
third-quarter results on Nov. 17. For such a richly-priced stock,
any stumble in this high-growth story could be painful.
Whole Foods Markets (NYSE:
This high-end grocer has always been richly-valued for its ability
to deliver very strong
growth on the heels of ever-expanding profit margins. Yet those
gains may soon be harder to come by as Whole Foods feels the
pressure of rising food
and a customer base that has already had to put up with a series of
price hikes this year.
The inability to boost margins further has already begun to bite.
After rising 69% in fiscal (September) 2010 and 35% in fiscal 2011,
Earnings per share (
are expected to rise around 15% in fiscal 2012 and fiscal 2013.
This makes the high forward multiple begin to stand out.
Of course, even if margin gains are a thing of the past, new store
openings can keep the top and bottom lines rolling. Whole Foods has
roughly 320 stores, and management thinks there is potential for
1,000 stores blanketing the nation. Really? It seems that Whole
Foods has done an outstanding job in all of the relatively affluent
neighborhoods in the United States that have the demographics to
support relatively expensive groceries. The next 680 stores aren't
likely to be nearly as supportive, especially in these stressed
times for consumers.
Those potential locales are already served by more traditional
grocery chains, all of which have taken note of the company's
winning formula. "Conventional grocery chains such as
have remodeled stores at a rapid clip and attempted to narrow the
gap with premium grocers like Whole Foods in terms of shopping
experience, product quality and selection of takeout foods," note
analysts at Morningstar. And those firms make do with much smaller
profit margins. Trader Joes, which serves the same audience, has
been opening 40 new stores a year in many of the same neighborhoods
that Whole Foods hopes to target.
Make no mistake, Whole Foods is an impressive growth story. But the
still-high forward multiple is ignoring the reality of a maturing
that will see slower earnings growth in years to come.
Risks to Consider:
A lot of these high-multiple stocks already have significant
short interest. Any further upward move in the broader market could
cause short sellers to cover their positions, sending these
Action to Take -->
Many of these stocks aren't so much clear short candidates as they
are candidates for profit-taking. History has shown that
high-multiple stocks take the deepest hits in a fast-falling stock
market. With all of the headwinds still in place, such a prospect
can't be discounted. So even if you aren't looking for a stock to
short, you should consider booking profits if you own any of these
-- David Sterman
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold
positions in any securities mentioned in this article.
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