Beware of 'Earnings Torpedos'

 | Sep 23, 2013 | 2:00 PM EDT
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We had split duties at Chez Melvin this weekend. The wife dedicated her time to seeing how much fall and Halloween decor she could get into the yard (she is the reason the displays are out so early), and I did research while watching sports. Although I had the disappointment of the Orioles playing themselves out of contention for the wild card in the American League, I did make some interesting discoveries that might help us make some money in the stock market, and the Ravens won rather convincingly.

As I have mentioned, I am something of a geek. Once I finished running stock screens and checking the stocks in my portfolio for any important fundamental changes, I surfed business-school websites for new papers or research articles that might contain significant information to help us as investors

I found a few of interest and will report back on them after I have digested them, but at the University of Michigan Ross School of Business site, I found something that interested me greatly and should interest you as well. The school is running two portfolios that are posted on its website. One includes stocks that are undervalued, and another one lists what the school calls "earnings torpedoes."

Earnings torpedoes are stocks that the students have identified as having the potential to blow up as a result of poor earnings. They use factors such as earnings quality, cash flows, momentum and valuation to identify stocks that could sink your portfolio. I checked through the historical lists the school keeps on the site, and the theory actually works very well at finding potential disasters and torpedoes that cause these stocks to underperform the market much of the time. I am cautious about the markets, and sometimes the best way to make money is to lose it, so the list is worth a review to see where danger may lurk.

The list is littered with energy-related master limited partnerships (MLPs). Many of these oil-and-gas-collection, transmission and storage partnerships have been bid up to very high levels as a result of strong oil prices and indiscriminate yield-seeking by investors. Billions of dollars have flooded into the sector as exchange-traded funds were formed to take advantage of the higher yields offered by these vehicles. Some of the better-known MLPs that are potential torpedo stocks are Atlas Resource Partners (ARP), Atlas Energy (ATLS), Cheniere Energy Partners (CQP) and Eagle Rock Energy Partners (EROC). Investors who own these names may want to review their holdings and consider lightening up on the shares.

The list is absolutely dominated by small-cap biotech stocks. Fifty percent of the list consists of biotechs such as Ariad Pharmaceuticals (ARIA), Vivus (VVUS) and Idenix Pharmaceuticals (IDIX). Biotech has been red hot this year -- the industry indices and ETFs are up more than 30% -- but investors might want to take some money off the table. I have long maintained that this is an incredibly specialized field, and if you don't possess, or have an adviser who possesses, a medical degree with a biotech concentration, small biotechs are dangerous for individual investors. Using ordinary fundamental or technical analysis techniques on these stocks is like playing financial Russian roulette, in my opinion. If you own individual small biotech stocks, it is worth your time to go the school's website and see if you are hanging on to a potential torpedo stock.

There are some big market darlings on the list that momentum investors need to be aware of before you take a torpedo amidships to your net worth. (CRM) has shown up on several of my lists of red-flag stocks in recent weeks, even as the stock has run higher in recent weeks. Since it has a forward earnings estimate multiple of 100x, the slightest disappointment from this company is going to cause an implosion in the share price, and all but the most nimble of traders should probably avoid the stock at this level

Zillow (Z) is another trader favorite that has had a nice run as housing markets have recovered somewhat, but it is now on the danger list. At more than 150x estimated profits, it would not take much bad news to explode the stock and your portfolio along with it.

It is worth your time to check out the torpedo list on the University of Michigan site. Even if you decide you do not agree with them on certain stocks or sectors it is thought provoking and educational. Tomorrow I will take a look at the stocks the students have identified as undervalued and see if we can find any potential gems to buy.

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