In investing, there's a time to focus on reward and a time to
focus on risk. And in a clearly growing
, it always pays to find the companies best positioned to grow
steadily. In better times, investors have been amply rewarded for
their focus on high-growth stocks like
Chipotle Mexican Grill (NYSE:
But right now, investors should focus on risk. I've been focusing
on the cheapest stocks in the market in the past few weeks, not
only because they have considerable upside when the market
rebounds, but also because their rock-bottom valuations tend to
lend meaningful downside protection. You'd be taking less risk if
you invested in a stock that's already well below
, or in a company that supports sustainable
free cash flow
More to the point, you should really be concerned about the
"reward"-type stocks right now, because they may take a hit from
two factors. First, their lofty
forecasts may need to come down once even the most
analysts start to realize the slow economy will crimp business.
Second, a lower target price-to-earnings (P/E) ratio on those
will likely shrink the stock price even more.
The stocks in the table below highlight the most expensive stocks
in the S&P 500 right now. (I've excluded
stocks, which are better valued on their assets than their profits
Of course, just looking at the P/E ratio doesn't tell you
everything about the stock. Telecom equipment maker
, for instance, may seem expensive at nearly 100 times projected
2012 profits, but the stock has support from more than $1 billion
in net cash, which is almost the entire
of the company.
But many other names on this list appear quite vulnerable, simply
because they may be sold off when investors have to choose which
stocks in their portfolio are worth retaining (i.e. the cheapest)
and which are worth unloading.
Let's take Netflix as an example. Back in May,
looked very expensive at 40 times projected 2012 earnings. The
stock has fallen by about $50 since then, so the forward multiple
is a bit more reasonable at roughly 30. The stock would be even
cheaper were it not for expectations of continued explosive growth
in 2012. This is because analysts predict sales could rise 38% to
$4.55 billion and per-share profits could soar 47% to $6.68.
Yet those analysts fail to account for a pair of factors that could
cause Netflix to undershoot these forecasts by a significant
. First, the company has recently changed its pricing plans,
separating out streaming customers from DVD-by-mail customers,
ostensibly to squeeze more revenue out of each customer. Trouble
is, Netflix streams very few titles that customers actually want to
see (as a movie-rental junkie, I could spend hours on this topic).
So how many customers may look to
rather than upgrade their service, as a few friends and I have
The other concern stems from market saturation. I'm hard-pressed to
find anyone in my social circle that has yet to hear about Netflix
and its service. To assume Netflix will keep finding new customers
at a very fast pace (while holding on to existing customers) may be
a mistake. Yes, Netflix is now moving into Latin America, but the
all-important U.S. market looks a lot closer to maturity than
analysts presume. If the forecast of 38% sales growth in 2012 --
which is ambitious -- needs to come down as I suspect, then shares
will see their multiple compressed, perhaps closer to 25 times
projected 2012 profits. When combined with lower forecasts, this
could cause the stock to fall another 30% from here.
I ran through my
concerns for this customer relationship software vendor in June (
which you can read about here
) and shares are off "only" 16% since then. They actually rose
higher after my bearish outlook, to then drop 30% during late
summer market rout. But at nearly 70 times projected 2012 profits,
the selling may not be done.
My biggest concern is analysts have yet to alter their bullish
growth forecasts for 2012, seemingly oblivious to the fact that
information-technology budgets are starting to get cut. Analysts
were slow to cut their outlooks for tech spending in 2008, even
after it had become apparent that a weakening economy put a crimp
on this discretionary area of spending. It looks as if it may be
Salesforce.com gets such a big P/E multiple because it has been a
phenomenal growth story. Sales grew at least 40% for seven straight
years until fiscal (January) 2009, though growth then slowed to
about 20% to 25% in the past two years. Growth is expected to
rebound above 30% this year, but this is largely due to
The concern for Salesforce.com is the same one for Netflix: Past
huge growth has led to a large sales base that gets harder to grow.
Analysts don't usually declare a market has become saturated until
a high-growth company suddenly hits a wall. And I have yet to find
the analyst that looks into how much of a potential market is left
for grabs. Salesforce.com will have to fight hard with rivals to
achieve any remaining organic growth. As I wrote in June,
are taking the customer relationship software niche more seriously,
so these types of firms have a tendency to compete very
aggressively on price."
This is why a multiple of 70 times projected 2012 earnings simply
seems unjustified in these sobering times. Any signs of growth
challenges could wreak havoc on shares.
Risks to consider:
These are high-beta stocks, so any sharp market rebound could
give a new lift to shares. This is why it's a challenge to short
these stocks. But if you feel tempted, then be sure to set
Action to Take -->
Your portfolio should have a clear tilt toward value stocks right
now. Focusing on high-growth names is a strategy best pursued in
times of rising markets and a growing economy. This bullish
backdrop is likely off the table for at least the rest of 2011.
If you decide to pursue growth-oriented names, be sure they look
inexpensive by traditional value-oriented measures such as
), price-to-earnings or price-to-cash-flow (P/CF). And by all
means, if you hold any of the stocks I mention above, then
-- David Sterman
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold
positions in any securities mentioned in this article.
© Copyright 2001-2010 StreetAuthority, LLC. All Rights Reserved.