Potentially Wealth-Destroying Stocks

 | Aug 12, 2014 | 2:00 PM EDT
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I spend the better part of my time flipping over rocks and looking in the corners of the market looking for stocks cheap enough to buy, no matter what the market is doing at the time. Every once in a while I like to look around to see what needs to be avoided by long-term investors. There are some stocks which, no matter how juicy the story, you just have to stay away from. The story may be great, but the valuations are impossible to justify and expose you to a real risk of permanent loss of capital.

One of the best ways to find potentially wealth-destroying stocks is to look for those trading at high multiplies of earnings and assets that also have clusters of insiders selling. As far back as the 1960s, the work of Lorie and Niederhoffer confirmed that when three or more insiders sold in a short period of time, the likelihood was that the stock would underperform. Professor Nejat Seyhun's work has confirmed in more recent timeframes that, as has real world experience.

Does that mean that all high-multiple stocks with insider selling will go down right away? Of course not. Some will go some more and then collapse. A few might even go on a tear and move much higher, as momentum money pushes the share higher regardless of valuation. However, as Stanley Druckenmiller reminded us recently in what is now one of my favorite investing quotes, just because you own the lottery does not mean you made a smart bet. If you continuously make bad bets, you may win a few, but eventually the odds are going to catch up with you.

Facebook (FB) right now is a classic example of a bad bet stock. It is a great story with all the billions of clicks and huge user base, but the stock is too richly valued. Let's do a little math. If Facebook can hit the analysts' aggressive growth rates and grows sales and earnings by 37% over the next five years, the stock is still rich. If Facebook can in fact grow sales at that rate, then the stock will sell at 4x sales, provided the stock price does not change from the current levels. The PE ratio, if the earnings grow at that pace and they hit the targets, would be about 17. In current times the shares fetch 79x earnings and 19x sales. There's almost no way in my mind to justify that valuation.

Insiders seem to have some little bit of doubt as to the sustainability of the price, too. In the last 30 days, six insiders have combined to sell $11.6 million worth of shares. If the momentum money continues to love the stock and the market conditions remain favorable, it could continue to go higher, but that's really not the smart bet at this price. If anything goes wrong, owning this stock could cause sudden and swift permanent destruction of capital.

JB Hunt Transport Services (JBHT) is another stock that has seen robust selling in the past month. Five insiders, including the CEO, have combined to sell more than $7 million worth of stock in the open market. The stock has had a pretty good run since the market bottom, rising almost four-fold, but the evaluation levels are now somewhat questionable for a trucking company. The economy would have to be growing at a much more robust pace to justify  a lower-margin business like trucking trading at 26x earnings  and 1.5x sales. JB Hunt is clearly a best-in-class trucking company, but the stock price is simply too high at current levels to justify investment. You can't even make a case of future growth expectations, as the PEG ratio is 1.76 right now.

Buying stocks with nosebleed valuations that are seeing heavy insider selling is not investing or trading, in my opinion. It more closely resembles a rousing game of pass the burning match. You may escape without injury, and there is an outside chance you might win the game. But if you hold too long and get burned, it is really going to hurt. It is just not a good bet and, as any gambler or trader can tell you, if you make bad bets long enough, luck will turn against you and your bankroll and account balance will suffer a permanent loss of capital.

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