Play to Avoid Getting Burned

 | Nov 06, 2013 | 2:00 PM EST
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I see in the news this morning that one of the betting slip stocks has missed expectations and is dropping sharply. I have heard several analysts say that the ride is over for Tesla (TSLA) and they are predicting the stock will continue to fall.

I have no idea if they are right but it highlights the dangers of buying stocks that trade so far above the value of the business that they are simply bets in a popularity contest. You are betting that the company will continue to execute flawlessly in the face of exaggerated expectations and that someone will like the stock more than you do at a higher price. You are betting that you are faster and smarter that the 500,000 other people trading the stock on a given day.

I am well aware that you can make money in these stocks. If you are good at spotting important social trends and jump on one of these before the move, you can make an enormous amount of money. You are not investing in a business, however, as much as you are betting you spotted a developing trend before everyone else. I am horrible at social trends. I carry a zippo lighter, tuck my shirt in and order a large coffee at Starbucks, so I avoid these types of bets at all costs.

Once these stocks have run up in price and trade at enormous multiples of earnings and assets, you are really just playing an expensive game of pass the match. I am surprised how many of the red hot marker darlings do not really have attractive fundamentals when you peel back the hood and take a good look inside.

If you take the high fliers and rank them on F-scores for fundamental improvement, many of them are neutral, or down right horrible, based on the ranking system developed by Joseph Piotroski to spot winners and losers.

Coming into today, Tesla had a score of 5, which is pretty much neutral. I suspect after this earnings report we will see the score decline even further. Netflix (NFLX) only earns a 4 when we apply the balance sheet and income statements test; it's an outright sell when measured by F-scores. The investor focus on subscriber counts and reported earnings hide the fact that it is not really a great business deserving nose bleed multiples.

Google (GOOG) only earns a 5 and does not appear to be worth anywhere near the earnings and cash flow multiples the stock is awarding the shares.

American Tower (AMT) has been a favored stock this year and sports an earnings multiple well over 50. The cell Tower REIT earns an F-score of just 4 and the balance sheet is heavily levered. If they miss earnings or have negative developments in the business the stock could head south in a fairly rapid fashion. UDR (UDR) is another REIT that trades at very high multiples and earns poor fundamental rankings with an F-score of just 3.

Of the market darlings that attract all the headlines, only Amazon (AMZN) stands out with impressive fundamentals. I love the company and use their services often, but the valuation is too excessive for me to own the stock at anything near these levels. At least with AMZN, you have a stock with rock solid fundamentals that continues to improve. You have less of a chance of disastrous surprise causing a permanent loss of capital. You are still very vulnerable to market risk as a high flier at triple-digit values will shed value quickly when the market turns.

As long as they hit the magic numbers laid out by Wall Street and the market is moving higher, betting slip stocks can seem like easy money. Markets do not always go straight up, however, and those companies with poor fundamental grades such as F-scores are almost sure to stumble and fall eventually.  Many traders suffer from a severe case of Lake Woebegone Disease and assume that they are in the class of above-average traders who will sell just in the nick of time.

Unless you trade full time as a professional, you probably are not going to be in the above-average segment of momentum traders. You are trying to compete after work and during lunch against traders armed with super computers, an assistant and a direct link to exchanges.

Odds are he/she will pass the burning match off to you and move on to the next victim. You may not be tracking the changes in fundamental conditions using tools like F-scores and credit models, but they are and they will see the changes coming before you can react.

Your best chance as an individual investor is to use the enormous time and size advantage you have over the professionals. Focus on fundamentals and business value. Ignore the momentum and hot stock strategies where you have no advantage and can get badly burned by one bad bet.



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