Avoid the Earnings-Torpedo Stocks

 | Mar 03, 2014 | 1:30 PM EST
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March is off to an interesting start with the turmoil in the Ukraine roiling markets a little this morning. I have stated my concerns about the number of caution flags from subjects like the market cap to GDP ratio and Value line Median Appreciation index that are indicating that we are well on the high side of fairly valued.

The counter argument is that low interest rates will continue to trump all and the economy will continue to slowly improve and the markets will continue to climb a wall of skepticism and worry. That could well be the case and we could be as one strategist recently opined be in the sixth or seventh inning of a mid-1990s type of market that goes much higher.

I have a dismal track record of market direction predictions so I try to just stay focused on safe and cheap stocks and keep reacting to what the market actually does rather than trying to profit from predictions.

No matter what the market does, it makes a great deal of sense to companies that have the type of fundamentals that have been predictive of poor future performance. If the skeptics are right, they will probably lead the market lower. If the bulls are right, there is a good chance they will lag the pace of the advance. Fortunately, we all have a set of tools that can help us identify and avoid these stocks.

One of the better tools comes from the Ross Business School at the University of Michigan. Each month they assemble a list of 1,000 stocks that have the characteristics of what they call earnings torpedoes. These are stocks that have the potential for "a rapid and precipitous decline in a richly-priced growth stock that is triggered by revised information about fundamentals underlying the stock." Their model looks at factors like value, quality, momentum and predictability to compile the list; it has actually done very well over time at spotting potential losers.

The potential earnings torpedoes list is dominated now by healthcare companies. Most of these are smaller bio-technology companies, a sector that has been quite frothy of late. I have no clue which biotech company will make an exciting breakthrough that will make our lives better or will help us live longer. I suspect few people without an advanced degree have much of a clue, either.

Many of the companies are burning through cash and are not even close to being profitable. More than half of the list of potential exploding stocks comes from this sector. It is one sector in which I do not think most individual investors should be involved without experienced professional assistance. If you insist on speculating in biotech, I would go the school's website before investing to make sure mine was not one of the 56 potential disasters.

Oil and gas master limited partnerships have a pretty strong presence on the list of potential weak stocks. About 10% of the list comes from this sector and I have to say I am pretty excited about that as a value investor. I already scooped up shares of Boardwalk Pipeline Partners (BWP) after that stock blew up last month and would love to own more energy transmission and storage assets at a huge discount to the value of the assets. The excess supply of natural gas has created pricing pressure for these firms and they are best avoided until they blow up no matter how attractive the yield may appear right now.

Several of the popular social media stocks make the list as well. LinkedIn (LNKD) is the biggest social media darling on the list. With the stock sporting a triple-digit price-to-earnings ratio the explosion would be huge if the earnings torpedo was to strike the company.

I use LinkedIn all the time but cannot think of a single valid reason to own a stock with this type of valuation. Along the same line, my wife is the queen of Yelp (YELP). But the stock is on the list of potential blow ups and has a triple-digit multiple of the profits analysts are hopeful they might make next year.

I do not have the space to list 100 stocks here but it is worth your time to check out the list  and make sure you do not have earnings torpedoes headed for your portfolio.

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