Too Risky to Hold

 | Oct 03, 2012 | 3:00 PM EDT
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Chipotle (CMG) got "Einhorned." Hedge fund manager David Einhorn has become well known over the past few years for detailed presentations that point out ridiculously overvalued stocks. He has identified some huge short-side winners dating back to the now-famous 2002 Allied Capital presentation at the Ira Sohn Investment Conference. He has followed that up with legendary short call on overvalued situations like Lehman Brothers and Green Mountain Coffee Roasters (GMCR). When Einhorn speaks, investors act, and Chipotle is his latest victim.

I wish I had his pull and could "Melvin" some stocks and sectors. I have warned of the dangers of owing market darlings like Chipotle and Green Mountain for many years. One misstep, one earnings miss, one "Einhorning" by a noted investor and several years of gains can disappear in a flash. Chipotle had a tremendous run from September 2011, but all those gains are gone from investors who missed the top. All but the most adept and nimble momentum investors and traders should avoid high-momentum stocks with mostly institutional ownership. Green Mountain lost three years of gains in just a few months when the momentum turned against it. There is no margin of safety at such valuations, so a decline is not a buying event but often a permanent loss of capital.

I ran a screen this morning looking for stocks that have had a sustained price rise, very high multiples of earnings as well as assets, and are over-owned by institutions. I added a filter to find those companies where there is a good chance earnings and revenue growth will slow over the next few years. These are stocks that traders should consider selling short and investors should eliminate or avoid in their long-term portfolios.

When I look at the resulting list of stocks, one group stands out. If I could "Melvin" a group of stocks lower, it would be the large-cap Real Estate Investment Trusts. Jim Cramer and Tim Collins have mentioned these stocks in the past day or so as a group that may be ready to roll over to the downside. The large asset allocation to real estate over the past few years has pushed stocks like Public Storage (PSA), American Campus Communities (ACC) and others to simply unsustainable valuation levels. It seems that the large pools of money looking for exposure to a real estate recovery have favored liquidity over common sense and property values. The large REITs have had tremendous runs and have very low yields right now. We may indeed be in the early stages of a real estate recovery but investing in REITs at 40x earnings and 3x book value is not the way to benefit from improving real estate markets. Simon Property Group (SPG) is a good company, but buying shopping centers at 40x earnings with a yield below 3% is probably not going to make you much money as a long-term investor in the shares. There are some undervalued small REITs worth your attention, but the larger ones are just dangerous at these levels.

VMware (VMW) is one of the most overvalued stocks right now. The cloud computing company continues to see strong demand for its virtualization products at services that lie at the heart of the move to the cloud. This is a great company in a great business but the valuation reflects that greatness and then some. At 50x earnings and almost 10x sales, there is no room for any missteps by the company. The enterprise value to earnings before interest, taxes, depreciation and amortization is among the highest ratios I have seen in some time at 32. I used the most aggressive earnings estimates I could find for 2015 and came up with a future intrinsic value of just $41 a share. Using today's numbers, the value slips to just $28 a share. The company could see a decline in licensing revenues next year and margins will likely narrow. This stock could easily go into a sustained free-fall if it misses aggressive analyst expectations. The stock is too dangerous for long-term investors at this price.

Even though I can't "Einhorn" a stock, I can point out situations that are too pricey to own and help you avoid a permanent loss of capital.

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