Back In the Danger Zone

 | Aug 21, 2012 | 5:00 PM EDT  | Comments
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Stock quotes in this article:

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Let's spend another day on my list of dangerous stocks, which are usually the most popular stocks among investors. They are good companies, for the most part, and may have a powerful demographic trend providing a tailwind. While that may sound like exactly what you want to own, the truth is that there is too high a price for everything. By the time the trend is identified and the companies have reported several great years of results, their own popularity works against them. It is still a good company, but the price is just too high.

Markets are subject to wild price swings, as we all know. If you own a stock at a reasonable valuation and it drops with the market, you can have a reasonable expectation that the inevitable subsequent rally will make you whole and even profitable. But if you buy stocks at a nosebleed valuation, you may suffer a permanent loss of capital no matter how wonderful the business. Microsoft (MSFT) and Cisco (CSCO) both dominate the tech industry and they have helped to change the world. If you bought into these shares at the height of their popularity, you may not live long enough to see the stock prices reach their former heights. If you bought into the big banks when they were churning out profits from mortgage and securitization in 2007, it will take years, if not decades, to see those stocks at their former highs.

I modified the dangerous-stock search to look for stocks with high valuation and institutional ownership, regardless of year-to-date performance. Large-cap real estate investment trusts continue to make the list. Institutional money has flooded into exchange-traded funds and other funds to catch a bottom in the real estate markets. It is a great idea, but the wrong execution. The bling-buying has pushed valuation to unsustainable levels. Early investors in names like Simon Property Group (SPG), Public Storage (PSA) and AvalonBay (AVB) have done very well. Buyers during the height of the crisis have seen their investment triple or more in four short years. New investors looking to call a bottom in real estate using these REITs are likely to see losses from current levels. With earnings multiples above 40 and yields of 3% or less, I do not see how even long-term investors can earn rewards that justify the risk. They are hard to short as money continues to blindly flow into real estate vehicles, but if I owned these high-multiple, low-yield REITs, I would be a seller.

Medical software company Cerner (CERN) makes a great product that is timely. Its software enables hospitals and other medical facilities to combine clinical, financial and management functions to improve operations and care. Revenue, bookings and backlog are all growing at a healthy rate. This is by all counts an excellent company with strong product offerings. Unfortunately, everyone has noticed. The stock trades at 35x earnings and institutions own almost 80% of the shares. Insiders are consistent sellers of the shares and have dumped more than 500,000 shares in the past six months.

Even after the recent selloff, Chipotle (CMG) makes the list. I am not a fan of the restaurant but my wife and daughter tell me it is excellent. It is a good company, but its success is priced into the shares at current levels. Institutions still own 98% of the shares and should the company miss estimates or lower guidance further, the exit doors will get crowded very quickly. The stock trades at 36x earnings and has an Enterprise Value/EBITDA ratio of above 17. These are irrational levels for a restaurant stock, and that could lead to a permanent loss of capital.

I do not know what the market will do the rest of the year. It may continue to climb the wall of worry or it could succumb to the news flow and poor economic situation and collapse. I do know that owning high-multiple stocks with a high concentration of institutional ownership can be very dangerous for your long-term financial situation. It is time for long-term investors to prune these dangerous stocks.

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