Danger Zone

 | Aug 20, 2012 | 4:30 PM EDT  | Comments
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Stock quotes in this article:

ulta

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spg

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lulu

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gmcr

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nflx

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sbux

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elli

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ua

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ben

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trow

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tol

To identify potentially dangerous stocks, I look for names that are heavily owned by institutions, that sell at high multiples to earnings and that are up a lot over the past year. These shares are usually priced for perfection, and anything less will send investors heading for what will quickly become an overcrowded exit.

Similar to all screens this is not a precise timing signal. Much of the time these stocks will keep going up for some time after making the list. Stocks such as Ulta Salon (ULTA) and Simon Property Group (SPG) have been on the list for several months as their share prices have continued to move higher. If you look at the momentum stock busts so far this year, many -- including Lululemon (LULU), Green Mountain Coffee Roasters (GMCR), Netflix (NFLX) and even Starbucks (SBUX) -- were on the screen before their downward spirals. The stocks on the danger list look very similar to other stocks before they collapsed, causing a permanent loss of capital.

The best-performing stock on my list is Ellie Mae (ELLI). This really is a company in the right place at the right time. It makes software that allows banks to streamline and manage the mortgage origination process. Not only does the software reduce the cost of origination but the company says it helps with the compliance process as well.

Even during a period of weakness for mortgage originators, Ellie Mae has been growing earnings at an impressive pace. Perfection, however, attracts attention. Analysts are falling all over themselves to raise the estimates for the next quarter and full year.

The shares are fully priced at 49x current earnings and 38x times the rapidly rising estimates. The stock has gained more than 500% over the past year, with most of the gains occurring this year. Institutions own almost 75% of the outstanding shares and seem to be piling into the stock -- 90 institutions were buyers of the stock in the second quarter while only 16 were sellers.

This one has strong momentum and can probably go higher as larger funds continue to buy. Investors should be somewhat cautious and keep an eye on earnings estimates for signs of slowing.

Under Armour (UA) is still on the list as investors have continued to snap up the shares. The stock has shot up 60% so far in 2012 and is up more than 100% over the past 12 months.

The stock is now valued in nosebleed territory at 60x trailing earnings and 37x the optimistic estimates for next year. Institutions own more than 90% of the outstanding shares, so the doors will be crowded if consumers continue to pull back in the second half and Under Armour falls short of estimates or reduces guidance. There is no margin for error in the stock, and it looks to me like the risk is far greater than any further reward.

Although institutions are still net buyers of Under Armour, selling by large funds has begun to pick up. Large fund complexes such as Fidelity, Franklin Resources (BEN) and T. Rowe Price (TROW) all reduced their positions in the stock last quarter. We have also seen heavy insider selling in the past month.

I really see no reason to own Under Armour, and if it moves much higher, I will be shopping for put spreads to short the stock.

Toll Brothers (TOL) shares have shot up more than 50% since I suggested them back in December. The stock is now on my danger list with a P/E multiple over 70x on trailing earnings and more than 30x on estimated earnings. They are the best-in-class of the builders, but homebuilding is still not a great business and the stock is way ahead of itself. I would be an outright seller of the stock and even consider shorting the stock at these levels.

We have seen several momentum darlings stumble on the fundamentals and cause wealth destruction this year. Keeping a danger list of overvalued and over owned stocks can help make sure you are not caught holding the burning match.

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