Red-Hot Stocks Can Bring Permanent Losses

 | Aug 09, 2013 | 2:00 PM EDT  | Comments
  • Comment
  • Print Print
  • Print
Stock quotes in this article:

csco

,

FB

,

lnkd

,

ko

As important as it is to be cautious and own only the cheapest stocks that have strong balance sheets in times of market concern or caution, it is equally if not more important to avoid dangerous stocks.

When markets turn, the stocks that are overvalued or have poor businesses will lead the way lower, and this can often lead to a permanent loss of capital. When the market darlings roll over and crack, there is usually a contraction of the earnings multiple that can be permanent, and it can take years or even decades for the shares to regain their former highs. Ask any tech stock investors from the late 1990s who owned a stock that plunged by 70% or 80% because of a multiple contraction, and they can tell you the difference between a permanent and a quotation loss of capital.

Some of this is just good old-fashioned common sense. If you are an investor who is not in front of the screen all day, then owning shares of the high-multiple market darlings such as Tesla (TSLA), Linked In (LNKD) or Facebook (FB) is just dangerous for your financial health. Stocks that have made huge moves higher also make huge moves lower in a correction.

I am not a fan, but I have friends who swear by Netflix (NFLX). It may offer a good service, but the stock is trading at five times the 52-week lows and has a triple-digit price-to-earnings ratio, These are good companies, but they trade at nosebleed multiples of book value, earnings and cash flows.

This is a classic case of "good company, bad stock," where the market's daily popularity contest creates risky valuations. If there is one whiff of bad news, these stocks can damage your net worth permanently before you can wrap up that conference call and log in to your brokerage account. There is no company worth a 100 earnings multiple for a sustained period of time, in my opinion. If you are an investor who has a career, kids and outside interests, owning the momentum favorites, especially after an extended run in the stock market, exposes you to unnecessary and often uncontrollable risks.

I do not see any reason to own any of the giant tech stocks right now either. Companies such as Cisco Systems (CSCO), Microsoft (MSFT) and IBM (IBM) don't make a lot of sense to me, given my concerns right now. They were excellent buys in 2009 and even into 2010, but they are pretty fully valued at this point. They are too large to enjoy extended strong revenue and earnings growth that might power the stocks higher. At best, they will be single-digit growers, and a soft stock market is likely to accord them single-digit earnings multiples. They are widely owned by the large institutions and funds, and in an extended selloff these stocks will be among the first sold to meet cash and margin calls. These new blue-chips could easily lose one-third to half of their market value if the warnings of successful investors like Seth Klarman and Sam Zell come to pass.

I also see no compelling reason to own those giant blue-chips that are struggling to grow revenue in the past few years. I love Coca-Cola (KO) products, but the company is experiencing very weak revenue growth and yet sports a P/E ratio of 21. McDonald's (MCD) has had revenue growth of less than 4% but has managed to wring 22% annual earnings growth out of its sales via cost-cutting measures. That is not sustainable. It is almost impossible for Wal-Mart (WMT) to grow a lot faster than the economy today, and the stock will sell at a much lower earnings multiple in a bad market.

It is virtually impossible for these giant, slow-growth companies to do something that will set them apart and outperform in a falling stock market. The mega-blue-chips have done a great job of protecting their profit margins in the last few years, but they will run out of costs to cut and people to lay off, and margins will contract. They can't provide meaningful upside outperformance, but they could lead a falling market lower. There is no reason for long-term investors to own them right now.

If you share my concerns about the market and the economy, it is important to own the cheapest stocks that have great balance sheets and the ability to survive until they thrive. It is equally important to avoid owning stocks that expose you to excess risks and a permanent loss of capital.

Columnist Conversations

My sense is that if yesterday's upmove was not the start of a vertical upside blow-off that is heading directl...
Oracle is today's top gainer in the S&P 500 following last night's Q2 earnings report. The stock op...
If AAPL is going to continue to rally....this cluster zone and prior swing high need to be cleared! This is t...
Yesterday and today was the classic case of watching realized vol. in the SPX and other indexes jump. The mark...

BEST IDEAS

REAL MONEY'S BEST IDEAS

Columnist Tweets

BROKERAGE PARTNERS

Except as otherwise indicated, quotes are delayed. Quotes delayed at least 20 minutes for all exchanges. Market Data provided by Interactive Data. Company fundamental data provided by Morningstar. Earnings and ratings provided by Zacks. Mutual fund data provided by Valueline. ETF data provided by Lipper. Powered and implemented by Interactive Data Managed Solutions.


TheStreet Ratings updates stock ratings daily. However, if no rating change occurs, the data on this page does not update. The data does update after 90 days if no rating change occurs within that time period.

IDC calculates the Market Cap for the basic symbol to include common shares only. Year-to-date mutual fund returns are calculated on a monthly basis by Value Line and posted mid-month.