It's Not a Popularity Contest

 | Jan 14, 2014 | 4:00 PM EST  | Comments
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Stock quotes in this article:

FB

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lnkd

,

twtr

,

cmg

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amzn

,

yum

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avp

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csco

On Monday, I talked about the dangers of owning high multiple stocks because of the speed at which tastes can change and stocks can fall. I want to expand that sentiment to high-multiple, overly loved stocks.

When I look at stocks such as Facebook (FB), LinkedIn (LNKD) and Twitter (TWTR), I have to wonder exactly how anyone makes a valuation estimate of these companies. How can you justify the price you are paying or establish a point where the stock is undervalued or overvalued? The simple answer is that you cannot. You are just making a popularity bet for the most part.

I get the story behind the stocks: social media is so ubiquitous that even an old curmudgeon like me uses them. They are the brave new world of social interaction and business networking.

My wife and daughter love Chipotle Mexican Grill (CMG) and I understand the attraction. With its clean floors and better food, it is kind of like a Taco Bell (which is owned by Yum! Brands (YUM)) for sober people. But that does not make the stock worth 53x earnings and 40x the always optimistically accurate analyst estimates. There is no way to justify the stock price -- even if you use the somewhat silly PE to earnings growth ratio -- the PEG on the stock is 2.5. Once again, you are making a bet in the world's longest ongoing popularity contest not making a rational bet on a business.

I understand the Amazon (AMZN) story all too well. I am a somehwat voracious reader and although I prefer a real book, the cost savings and convenience drove me to the Kindle. I probably buy four or five books a week from the company. If I can buy it on the site and have it delivered vs. going to the dreaded mall, then I do so. I am on a first-name basis with all the delivery service drivers in the area. That does not mean the company is worth 1300x earnings and 130x the estimates and almost 20x book value. The PEG ratio is over 30. It is a fantastic company, but at current prices, it is also a bet and not a rational investment.

These sorts of stocks can -- and often do -- go up for a long period of time. More than one would-be hero has been carried out of the arena on a bloody shield trying to short them. However, I have been around a very long time now and with very few exceptions these things all fall apart. From the "nifty 50" of the 1970s to the Internet bust of the early 2000s -- and every little mini momentum bubble in between -- they all fall to earth. The companies probably survive, but they trade at much lower valuations. Ask the folks at Avon (AVP) or Cisco (CSCO) how that works.

Everyone I talk to thinks they will be among the really smart guys who get out before the valuations crack and the stock drops off a cliff. You won't be. Here is exactly how this plays out. After several years of great gains you get the first healthy break in the stock. This is an incredible opportunity to buy a great company at 20% off!  Round up some cash and buy the dip. You are exalted as the price initially rebounds a bit and confirms your superior stock picking skills. Then we get the second leg down and things are a little more worrisome. You aren't going to spend any more cash -- most likely because you are out of it. Still, you aren't selling because this is one fantastic company that is changing the world and trading at half the price it did just a few months ago.

When the price continues to fall, you resolve to sell this thing the moment you break even and never make this mistake again. After one more round of analysts' downgrades and estimate reductions, the stock plunges again. You finally give up in disgust and book your losses, usually by selling to guys like me: bottom-feeding vultures who have waited patiently for a few years for this opportunity.

When valuations become extended and you can no longer rationally value the company anywhere near the current levels, you are making a bet that someone else will be willing to buy from you at an even sillier price in the future. What you are not doing is making a rational bet and maintaining a margin of safety. Unfortunately, even though these types of stocks can make some wonderful multi-year moves, eventually, the party ends and it is never "different this time."

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