Over the past two months, the market has mercilessly punished
sexy, highly valued stocks. The bloodbath shows yet again that
investors ignore the price of a stock at their peril. And despite
the plunge in share prices, these former high fliers are still
nowhere near bargain levels.
With few exceptions, the companies that took the brunt of the
shellacking are involved in either biotechnology or "new
technology." Many of them only recently came public. They're
generally involved in businesses everyone is talking about,
everything from 3-D printing to cures for hepatitis C.
Most hit all-time highs around the end of February--after big
run-ups earlier in the month. Here's a glimpse at the damage to
some of the stocks since March 3: Amazon.com (
), down 17.3%; Dendreon (
), 27.2%; LinkedIn (
), 29.3%; Netflix (
), 26.8%; Plug Power (
), 34.7%; Salesforce.com (
), 15.8%; Shutterfly (
), 27.0%; Tesla Motors (
), 17.3%; and Vertex Pharmaceuticals (
), 18.4%. (All returns are through May 6.)
The focus of the selling has been on story stocks--that is,
companies that lure investors, and their dollars, with good
stories. A lot of that money, probably most, comes from hedge funds
and other fast-trading professionals who buy stocks that are rising
in the hope that their momentum will continue to push share prices
skyward. Once momentum stocks reverse course, these traders make
haste for the exits.
Individual investors also buy these stocks, and I fear many of
them have little idea of how overpriced they are.
So let's quickly review the basics. There are dozens of
different ways to value a stock. The simplest is the price-earnings
ratio. Say a stock is trading at $15 a share, and analysts, on
average, think it will earn $1 in the coming 12 months. The stock
has a P/E of 15--which just happens to be the long-term average for
the stock market.
Now consider these high fliers' P/Es based on estimated earnings
for the next 12 months: Amazon, 192; LinkedIn, 80; Netflix, 69;
Salesforce.com, 104; Shutterfly, 80; Tesla Motors, 117; and Vertex
Pharmaceuticals, 59. P/Es aren't available for Dendreon and Plug
Power because those companies are expected to lose money over the
next 12 months.
Putting this in simpler terms, paying a P/E of 50 is like
spending $5,000 to buy a lemonade stand that you think will
generate $100 in profits over the next 12 months. At that rate, it
takes 50 years to make back your cost, assuming profits never
Of course, you have to make allowances for anticipated growth.
You'd expect to pay more for a company that seems likely to
increase its earnings by 20% a year than for one that's only a 10%
grower. That's common sense.
Where common sense turns to nonsense is when
investors--professional or amateur--predict that a company's
earnings will grow at a torrid pace--say, 30% or more annually--for
five years or more. A handful of companies do end up growing that
rapidly, but only a handful. Why? Mostly because of competition. If
a growth opportunity is that huge, you can bet other companies will
rush to cash in, too.
That's why I wouldn't touch these stocks today, even at their
reduced prices. I'm not saying they won't bounce back. No one can
predict short-term market moves. And a few of these companies
undoubtedly will become long-term success stories. But the odds are
against you when you buy such expensive fare.
What's troubling is that we've all seen this movie before.
Technology stocks went through the roof in the late 1990s, then
crashed in the 2000-02 bear market. Did investors--I use the word
Jeremy Siegel, a longtime stock market bull, wrote a bearish
piece for The Wall Street Journal in early 2000 just as tech stocks
were peaking. In the article, he cautioned: "History has shown that
whenever companies, no matter how great, get priced above 50 to 60
times earnings, buyer beware." Siegel is a finance professor at the
University of Pennsylvania's Wharton School and
a columnist for
. I liked his quote so much that
I used it in an article published last fall warning
of overpriced technology stocks
At the same time, I wouldn't worry about the recent selloff in
overpriced stocks spreading to the wider market. The excesses are
as bad as they were in the late 1990s, but they're occurring in
much narrower corners of the market. What's more, most reasonably
priced stocks held up well during the recent tech meltdown.
Want to own tech? Consider Technology Select Sector SPDR ETF (
). The average P/E of the stocks in this exchange-traded fund is
16.6. The fund holds solid old-tech names such as Apple (
), Microsoft (
) and International Business Machines (
). These companies aren't sexy, but neither do they trade at insane
is an investment adviser in the Washington, D.C., area.