We’ve spent a lot of time talking about how to identify great companies with huge upside potential. No doubt you’ve got the 3-Step Total Wealth Process down by now: 1) identify the trend, 2) pick your trade, and 3) control your risk.
So today I want to shift gears and talk about the one metric you can use to identify seemingly pristine companies that are ripe for a fall.
Our timing couldn’t be better. Janet Yellen has just taken off the blinders and the markets charged higher… at a time when corporate profit growth is about to go negative for the first time since the Financial Crisis began and QE started.[ad#Google Adsense 336×280-IA]Meanwhile, there are fears of another recession, flat wages, and even flatter consumer credit.
Obviously the stronger companies will survive and that’s in large part why we concentrate on them.
But the weaker ones… whoa Nelly, they’re in for a wild ride.
How do you know which is which?
Fortunately, that’s not hard – there’s one number that can tell you which way to play it.
Learn to “read” it properly and you’ll have a tremendous advantage over most investors, for whom hope is unfortunately a viable investment strategy.
Here’s the indicator that makes the difference between a “buy” and a “short.”
Chances are, you already know about the Price to Equity (P/E) ratio. That’s the ratio of a stock’s price to its earnings. It’s a simple tool, and that’s why it’s so powerful.
I’ve covered it here for Total Wealth readers – specifically, when describing how I knew that Altria Inc. (NYSE:MO) was a terrific “Buy” opportunity even when it was brushing up against 52-week highs.
And you probably know that it’s one of the most commonly quoted of all financial measures. So common, in fact, that it’s become ubiquitous… not to mention overlooked.
I’ll bet that 99% of investors don’t realize how important the ratio is. They have no idea it can make or break stocks in the short term, often resulting in quick double- or even triple-digit gains for investors and traders who really understand what they mean.
In a nutshell, high PE companies are “expensive” because the price is bid up disproportionately to earnings. Rallies usually start in the single digit PE range while retracements typically begin when PE ratios are north of 25. Not always, mind you, but enough that this rule of thumb holds true for our purposes. Right now the average S&P 500 stock sports a PE of 19.72, which is a little on the expensive side… but clearly not in bubble territory, just for perspective.
Let me show you a recent example.
How Tesla Stock Caught Up With its Fundamentals Last Fall
You would have been hard-pressed to find many analysts labelling Tesla a “Sell” last September. The stock was on a terrific run that had resulted in a 32% gain since July, amid high oil prices and well-received earnings reports. It was almost universally hailed for its great potential – to the point that the stock got ahead of its inherent worth, trading at 133 times forward earnings, in contrast with Facebook’s forward P/E of 43. It was an alarmingly lofty valuation, even for a company with real promise that also happens to be blessed with one of the most innovative CEOs on the planet.
Ironically, one of the few experts to warn against Tesla’s overvaluation was Elon Musk himself. On September 1, 2014, he warned that TSLA stock was “kinda high.” Sure enough, TSLA would fall 20% lower within a month, and it’s drifted downward since.
To be clear, I wouldn’t bet against Musk longer term. I believe there are several companies actually trapped inside Tesla at the moment that will ultimately come into their own. A decade from now, Tesla will be a very different company.
But shorter-term, Tesla is a great example of how even a magnificent company with sterling leadership can’t stray ahead of its fundamentals for long without crashing back down to earth.
Tesla’s P/E ratio told us what too many analysts wouldn’t, and what most investors can’t fathom: that the stock was simply too expensive, and didn’t merit a “Buy” at the time. But it did merit a terrific short (or a bet that the company’s price would fall).
Anybody who took that trade enjoyed gains of more than 40% as Tesla’s price came back down from the stratosphere.
Today you have a similar opportunity with three iconic and well-regarded – but similarly overvalued – companies that have gotten significantly ahead of their fundamentals.
Iconic Stock to Short #1: Shake Shack Inc. (NYSE:SHAK)
Shake Shack Inc. (NYSE:SHAK) IPO’d only last month, but it’s already causing a lot of commotion in the fast-food industry. From its humble beginnings as a food cart in Madison Square Park in 2000, the chain has now grown to a 63-store empire that’s in the process of expanding westward. It’s got a solid reputation as a deluxe fast-food restaurant selling grass-fed, antibody-free beef at prices that are some 50% higher than McDonald’s burgers… yet seem to be grabbing precious market share from the Golden Arches.
Just as impressive, Shake Shack already has a social media presence that has astounded observers by amassing more Instagram and Vine followers than far older and more famous companies like McDonald’s, Burger King, Taco bell, and even the erstwhile fast-food upstart Chipotle. That speaks to very strong Millennial appeal that you would think bodes well for the stock’s long-term outlook.
Yet Shake Shack sports a P/E ratio that would make last September’s Tesla bulls blush. It’s an astounding 679 times earnings.
If you aren’t mathematically inclined, the PE ratio can be thought about simply: What it’s telling you is that the stock price is so high that you will have to wait 679 years to break even on your investment.
It reminds me of Krispy Kreme Doughnuts (KKD), which also came out of the IPO gate hard and fast… then tanked when everybody realized that you couldn’t ever sell enough donuts to match the high expectations expressed by enthusiastic investors.
I say that because Shake Shack announced a 51.5% increase in revenue in its earnings report on March 11. That’s impressive, as was the tiny quarterly net loss of $1.4 million, because it means the company is keeping things under control… for now.
Iconic Stock to Short #2: Palo Alto Networks Inc. (NYSE:PANW)
It’s not a secret that America’s tech sector is booming. Over the years, it’s been an absolute bonanza for network security companies, but especially Palo Alto Networks Inc. (NYSE:PANW).
So much so, in fact, that the company’s stock has actually outpaced America’s tech boom over the last nine months, and doubled in price since last May.
But as is so often the case, what goes up must come down.
PANW announced negative earnings in March that could be the first in an unpleasant line of quarterly numbers that rip the mask of deeper problems not yet recognized by most investors. It’s not for nothing that the PE is negative… basic math says you cannot have a positive number if there are no earnings.
And in this case, there aren’t. It’s not for nothing that according to Yahoo!Finance, the company’s return on equity is -62.89%.
Iconic Stock to Short #3: Acadia Pharmaceuticals Inc. (NasdaqGS:ACAD)
Like PANW, Acadia Pharmaceuticals Inc. (NasdaqGS:ACAD) has had a decent 2015 – at least if you ignore earnings.
The biotech company has already suffered a sharp 20% drop since its Q4/2014 earnings report released last February. The company reported a loss of $0.28/share – 12 cents worse than analysts had predicted – but the real sign of chaos came on March 10, when CEO Uli Hacksell announced his surprise retirement, effective immediately.
Having suffered three negative revisions from analysts in the last month, we’re clearly not alone here in our thinking. Short interest (that’s how you measure the positions being bet against any given company) is now 8.14% of float, which is well about the 5.15% average for comparable mid-cap companies.
Factor in that its 2015 earnings consensus has also inched downward in the last 30 days, and it’s clear that this $3.5 billion biopharmaceutical company still has a long way to fall.
Now, with regard to tactics… shorting stocks requires margin because of the way it works. (Check out my prior articles on the subject.) So you’ll want to take steps to minimize risk just as you would any other investment.
Unlike bulls, bears tend to move sharply and quickly. And it’s not uncommon for a trade to go against you – meaning, rise further – before the fall that ultimately takes it down. Survival is a powerful instinct.
Ultimately, no company can survive outrunning its fundamentals for long.
And that’s why you want to make shorting a part of your overall thinking, if not your investment process, every now and then.
Until next time,
Source: Total Wealth