I had a manager at a firm I used work with. This guy had been in the investment racket for what seems like forever. He was always available to give young brokers advice on stock selection. He would refer to stocks that carried too much risk as “chocolate covered hand grenades.” They looked enticing but sooner or later were guaranteed to blow up in your face.
Coming of age in the business during the Tech Bubble of the mid-1990s, I learned a lot about ridiculous valuations.
Stock prices and investor expectations can get a little over their skis if the right conditions are present in the market.
The S&P 500 index has delivered around a 5.5% return year-to-date, sparking the pundits to wring their hands and wonder aloud if the market is overvalued.
The S&P 500 is currently trading at about 18 times expected earnings.
If you’re a value-oriented investor, then that may seem a little expensive, especially if forward P/E is one of your primary valuation metrics. Otherwise, there’s not really cause for widespread concern about the market.
However, I’ve identified three widely traded stocks that I would categorize as chocolate covered hand grenades. At their current levels, I’m amazed they haven’t already exploded.
1. Amazon.com (Nasdaq: AMZN)
As a consumer, I absolutely love Amazon. Just about every Hanukkah and Christmas gift exchanged in our house this year came from Amazon. I joined Amazon Prime just to watch The Man in the High Castle. Amazon Studios won an Oscar for best picture. I get it. It’s an amazing business… that doesn’t make money.
As an investor, I have been scratching my head for nearly 20 years wondering why anyone would buy the stock. Ok, I realize that if you’ve owned the stock, you’ve made an obscene amount of money (136% on an average annual basis over the last ten years).
Numbers don’t lie, right? Call me old fashioned, but I still believe that what you pay for a share of stock should represent that company’s ability to deliver consistent earnings. Not sales, not an idea, but tangible earnings per share. Apparently, that rule doesn’t apply to Amazon. Over the past five years, the company has grown sales at an impressive 23.1% average annual rate. Earnings per share (EPS) is a different story. Amazon’s EPS have declined at an average annual rate of 219.45% for the same period.
I don’t understand it. Amazon rarely makes any significant, bottom-line earnings gains, meaning it is adding absolutely zero value to shareholders. Investors are just trading bits of paper back and forth.
2. Netflix (Nasdaq: NFLX)
Netflix is another brilliant tech disrupter. They composed the requiem for brick and mortar DVD rental with an online/mail model, all while investing heavily in technology and infrastructure to help kill the DVD altogether with streaming. Using the same subscription model, the company made the jump to light speed, offering access to plenty of film and television content and eventually expanding into producing its own, widely-embraced content.
But while Netflix is a card-carrying original disruptor, the odds are stacked against the company. Streaming is now the fastest growing content delivery method and everyone is fighting for slices of the same pie. Netflix is going head to head with the likes of Amazon, Comcast (Nasdaq: CMCSA), AT&T (NYSE: T), and Verizon (NYSE: VZ) to name some of the biggest hitters. The competition for shrinking market share in a crowded space will be brutal. Eventually, content will be the deciding factor and the question will be whether Netflix generate the kind of cash flow needed to fund competitive content.
Today, the answer is no. Last year the company had net cash flow from operating activities of -$916.82 million. Compare that to Comcast’s $19.25 billion in net operational cash flow and you’ll see that Netflix is facing an incredibly steep climb. The stock’s current valuation at $144.50 per share with a forward P/E of 130 is just not sustainable with that kind of outlook.
3. Tesla (Nasdaq: TSLA)
Helmed by billionaire Elon Musk, the real-life inspiration for Tony Stark of Iron Man fame, Tesla singlehandedly made electric cars sexy. Musk’s vision also stretches beyond the stratosphere with his for-profit, private space program, Space X. The stock, though, seems to be capable of defying gravity and surviving in a zero-oxygen atmosphere as it currently zooms around $300 a share.
Earnings? There are none. In fact, the company has grown its annual per-share loss at an average rate of 372% over the last two years. The company projects profitability of $2.06 by year-end 2018. We’ll see…
Sales are a different story. Revenues have grown at an average annual rate of 129% over the last five years. The 2017 forecast calls for a 63.5% jump topping 2016’s $7 billion in sales with $11.45 billion in anticipated revenue. (Odd that it’s such a flat, round number. Maybe that’s just me, though.) While this would be an impressive achievement, it would slow revenue growth on a percentage basis, making tangible profitability even more elusive.
Another non-encouraging factor is the “gigafactory” project Musk’s is shoveling piles of money into. Retaining capital tends to help earnings, too. Why not partner with someone in the battery business? Just a suggestion.
Risks To Consider: It’s funny to talk about inherent risks in demonstrably risky stocks. The best way to avoid losing money is not to own the stocks. But if the economy does continue to improve, the stampeding herd will continue to inflate any stock market bubble by bidding up the most overvalued speculative names out there.
I guess I’m trying to say that staying away from these three stocks may equal leaving money on the table. If investors feel they absolutely must have exposure to this asset class, the best way would probably be a well-run growth fund that holds these stocks but spreads the risk by also owning higher quality names.
Action To Take: There’s no fundamental need for investors who seek quality growth to own these stocks which, collectively, trade well beyond their earnings capabilities. Remember, a share of stock represents a share of real, tangible, sustained earnings by a company. None of these companies display that quality.
However, if I had to make some predictions, I would say that Amazon eventually will be consistently and qualitatively profitable. Netflix will probably be purchased by a rival. As for Tesla, unless it releases some kind of light bulb, Thomas Edison-style technology in the near future, there’s a decent chance that the Model S could replace the DeLorean as Doc Brown’s time machine in a Back to the Future reboot.
— Adam Fischbaum
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Source: Street Authority