Too Enticing for Their Own Good

 | Apr 23, 2013 | 5:00 PM EDT
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On Monday I addressed utilities, a sector that's poised to offer very little total return for the next three to five years, according to Value Line. That total-return metric is at a five-year low for the entire universe of stocks covered by the service, and that tends to throw up something of a caution flag for the broad market -- yet it appears that the flag is a deeper red for the utility sector. But utilities aren't the only stocks with particularly low projected returns.

Many of the other names that fall into this category are very good, if not great, companies that are achieving some measure of corporate success. However, the always-overoptimistic Wall Street crowd has fallen in love with these companies and pushed the shares to levels that are simply unsustainable. One such company is the business-networking website LinkedIn (LNKD). I have a LinkedIn account, and I like the site. I have several friends who have improved their professional situation via LinkedIn. The company has grown at a pretty impressive pace so far, and that growth will probably continue for several years.

However, we have a "great company, bad stock" situation developing here. The current valuation already reflects everything good that could possibly happen to LinkedIn. The stock sells for almost 1,000x current earnings and more than 80x the too-high Wall Street projection. It fetches a very Internet-bubble-like 20x revenue, as well as 220x free cash flow. Yes, the stock has done very well for investors, having quadrupled from its initial public offering price in less than two years. But no company can live up to the expectations currently baked into the price, and investors would do well to avoid it.

Madison Square Garden (MSG) is another company for which the stock price may be a victim of its own success and popularity. Everything is going right for MSG. The NHL strike is over and hockey is being played in the Garden again, and the New York Rangers will probably make the playoffs. The Knicks are currently in the playoffs, and many NBA observers think the team can make it to the title game at least. Tourists have continued flocking to New York, and that means strong revenue out of MSG-owned Radio City Music Hall, in addition to concerts and special events.

However, all of this is already reflected in the current price of the stock. Madison Square Garden shares trade at 34x earnings and 31x projected earnings. The company owns tremendous assets but, at more than 3x book value, investors are paying a premium price for them. The share price has almost tripled since the 2010 spinoff, and any shortfall in earnings or revenues could send the shares tumbling lower. So, at this point, the stock would best be avoided by long-term investors.

At the opposite end of the quality spectrum is Caesars Entertainment (CZR). Business is not particularly good here, as loosened gambling laws have led to increased competition. The company recently lost its bid to gain a license in Macau, the global hotspot for casino gaming. Caesars owns a lot of property, with 52 casinos and more than 43,000 hotel rooms, but it is also highly leveraged. It has been selling some assets in order to pay down debt, but many of its properties cannot be sold because of restrictive debt covenants.

On Tuesday, Caesars announced that it is setting up a new entity along with its private-equity owners Apollo (APO) and TPG Partners. The venture will buy a Planet Hollywood casino from the company. However, I doubt this will be enough to get the balance sheet cleaned up to the point at which the company can produce free cash flow or earn a profit. Caesars carries more than $20 billion in debt, and Moody's recently cut its rating to just two steps above the default level.

In fact, if you think Caesars can pull off its business plan, the debt -- which yields a 20% -- is a much better investment than the common stock at this level. The stock has risen sharply on the day, and you would be ill-advised to chase it at these levels. With margins under pressure from competition and a slow domestic gaming market, a financial-engineering loan will not be enough to justify long-term investment.

More broadly, as well, several caution lights are flashing in the market right now -- so investors are advised to read carefully and avoid overpaying for stocks. Sometimes you win more by avoiding losses than you do by finding winners. This may well be such a time.

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