The Curse of High Expectations

 | Jul 23, 2013 | 2:00 PM EDT
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In Monday's column, I discussed the reasons I believe the market is near or at overbought levels. Today, I want to talk about some of the most vulnerable stocks in the market should we get a significant decline, or they experience any company-specific disappointing news. This group of vulnerable stocks consists of the high growth/high price-to-earnings stocks that have turned in stellar performances so far in 2013; however, they have gone up so much that they have significantly overshot any kind of reasonable valuation in some cases.

I understand the attraction of riding equities that are showing substantial revenue gains given the overall market is showing no sales growth this quarter. But growth investors are making some of the same mistakes yield investors made earlier in the year. Through April, income investors bid Utilities & Consumer Staple stocks to high up in their historical valuation ranges and then took significant hits as these sectors pulled back starting in May on rising interest rates.

Given how "priced to perfection" some of the stocks in this high-flying contingent are, they could deliver even more pain than income investors recently experienced if the market slips back or they deliver any sort of negative results.

One need only look at Intuitive Surgical (ISRG) to see what happens when a high flyer disappoints. The stock has lost almost $200 a share in market value since its highs earlier in the year on one tepid earnings report and an FDA warning letter. Netflix (NFLX) is another good example, as the company delivered earnings last night that beat earnings estimates by $0.09 per share, but the stock is getting hit nonetheless as subscriber growth was a little less than expected. Tesla (TSLA) is the poster child of a stock with a huge run-up but whose market value rests on extremely optimistic assumptions. I have covered these shares recently, so I will not cover the reasons I am skeptical of any additional capital appreciation gains at these price levels. Instead, I will call out two other high flyers I would avoid.

Splunk (SPLK) is a cloud software play that went public in April 2012. Despite the lack of earnings to this point, the market has deemed the stock worthy of a market capitalization of more than $5 billion. The stock is up some 60% this year to $50 a share, though even consensus forecasts are for no earnings this fiscal year and just $0.12 per share in 2014. Share gains have been driven by 30% plus revenue growth, and there's speculation the company could be acquired. The stock sells at over 20x annual revenues, though, and insiders have sold more than $10 million in shares in July alone, and the stock seems to be unable to break through the $50 level recently.

Zillow (Z) operates a real estate and home-related information marketplace on mobile and the Web. The company has ridden the housing recovery more successfully than some of the homebuilders, which themselves are up substantially over the last year. The stock has more than doubled in 2013, even though it is tracking to a small loss for 2013. The company has a more than $2 billion market capitalization, even though it will have less than $200 million of revenues in this fiscal year. The stock has shot up some 20% in the last three months, even as consensus estimates for both 2013 and 2014 have significantly and consistently come down. A good portion of rise could be due to a short squeeze, as some 25% of its shares are held short. Signs that a housing recovery is slowing down could hit sentiment on the stock at some point as well.

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