Don't Wrestle With These Stocks

 | Aug 23, 2013 | 3:00 PM EDT
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It's no secret that I find this market more than a little scary. This is mostly a result of very few new opportunities to put money to work in cheap stocks, which has always been something of a red flag to me. But the current mixed bag of economic reports, rising interest rates and poor earnings and guidance adds fuel to my uneasiness. The fact that some of the greatest investors of my lifetime, like Wilbur Ross, Sam Zell and Seth Klarman, have made cautious if not outright negative views on the market in recent months does not do much to add to my comfort level.

I'm not a market-timer by any stretch, and I don't make market calls or suggest going to cash or shorting the indices. That is not my style, and I am not very good at it. Most of my time is spent kicking over rocks in dark corners of the securities markets looking for stocks and bonds to buy regardless of market conditions. If I find something cheap enough that passes my margin of safety checks, I buy it regardless of what the market is doing. But I am pretty good at finding stocks that are overvalued and are best avoided by investors.

Some are obvious. If you own the giant momentum stocks with triple-digit multiples, you are taking on enormous market risk. These may be great companies with exciting products and widgets, but if the market turns, they will be crushed by multiple contraction. Those who trade should already know this, and there are many folks to ring the alarm on those types of stocks.

I ran a screen to look for another type of stock to avoid regardless of what the market is doing: those that have seen earnings and book value decline over the past five years but still trade at high multiples of earnings and asset values. Here, the company is losing value but investors are still paying up for the stock. Regardless of market conditions, paying too high a price for a struggling company is a serious mistake.

Gibraltar Industries (ROCK) is an example of such a company. It manufactures and distributes metal products for residential and commercial construction. The stock is down from its highs, but I do not believe it is even close to a bargain. The stock trades for 16x book value, 111x cash flow and 55x trailing earnings. That's too high for a company that's not growing gangbusters, much less one that is not growing. The company has seen earnings decline steadily over the past five years and tangible book value has fallen by half. There is no compelling reason to own the stock. I wish there were, as I believe the industry will recover over the next five years. But until the EV/EBITDA ratio falls below 5 from the current 7.9, I suggest avoiding the stock.

It may upset my good friend Brian Sozzi, but I see no valid reason to own shares of World Wrestling Entertainment (WWE), either. I get that it has a rabid following among teenage boys and adults with a horrid case of Peter Pan Syndrome, but there is no reason to own this stock, in spite of its generous dividend. I have maintained for years that I believe the dividend is a mechanism for the McMahon Family to take cash out of the company over time. They do not earn the dividend, and tangible book value has declined every year since 2006. Sales have been flat over the past five years while earnings have declined by an average of about 10% annually. If I am right that the dividend is just a transfer mechanism, then the stock is worth the discounted value of the payouts, or about $6. That's roughly 40% lower than the current stock price. There is no upside and substantial downside, so I see no reason to buy or hold this stock.

No matter what your opinion on market direction, these stocks are best avoided. The valuations do not allow much upside if markets keep rallying, and they could shed value very quickly on a decline. Not suffering a permanent loss of capital is just as important as making money on the upside.



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