January is a good time to check in with our friends at the University of Michigan Tozzi Financial Center. The students at the center, which is part of the Ross School of Business, run two experimental portfolios that are updated every month. They use factors based on academic research to put together two portfolios, the Value 40 list of stocks to buy and the 100 Earnings Torpedo stocks that investors should avoid. The factors used include some of the more durable market anomalies including value, momentum, quality, predictability and smart money, to identify stocks to buy and avoid. It has worked pretty well, as the long portfolio usually outperforms the market and the list of torpedoes dramatically underperforms the market most years.
I will start with the list of potential torpedoes. In today's pricey equity environment, I suspect the surest way to win is to avoid losing big. The Torpedo List has been a pretty source for spotting stocks to avoid. I have tracked the list for several years now, and it is surprisingly effective at identifying risky stocks that could cause serious damage to your portfolio.
Once again, the list is dominated by small biotech companies. I have met many people over the years who like to speculate on small biotechs, looking for that long shot that pays off big, with a blockbuster new drug. I have not, however, met anyone who has done so with lots of success. The only successful small biotech investor I have ever met is a friend who has a medical background. He would short every little biotech company that saw a price pop after a successful phase. He told me that so few of these companies every got the drug to market that shorting the price pop was akin to free money most of the time.
Many of these companies have no product to sell yet, and they burn cash on research and development. Most of them are just hoping to get far enough along that they get a research partnership or grant from one of the large established pharmaceutical companies. These stocks are betting slips, not investments; those of us without advanced degrees in medicine or biotech should avoid them.
Under Armour (UAA) is on the list this month. The company has fallen out of favor on Wall Street of late, and the stock is down 25% in the last three months. Under Armour is a decent company with good products, but the simple truth is that the price is still too high right now. The stock trades at 40x earnings and any shortfall on earnings or other less than wonderful news could send the shares tumbling further. One analyst said that his channel checks show that sales of the Stephen Curry line of athletic shoes are slowing, and that could easily drag earnings below analyst estimates at some point in 2017. With momentum already negative, the stock could fall very quickly.
Zillow (Z) is another high-multiple Wall Street darling that makes the list of potential torpedo stocks. Zillow operates real estate and home rental sites including Zillow, Trulia, StreetEasy, and HotPads and the recovering real estate markets have been a boost for the company. Hopes for an even stronger housing market under the new administration have pushed the stock higher, but you are paying a very high price for hope with this stock. Zillow is not profitable right now, and although analysts expect it to make money over the next year, you are paying over 5x hoped-for profits right now. Zillow is priced for perfection in an imperfect world, and that has been a dangerous combination, in my experience.
Square (SQ) has also been a hot stock in the past year. Wall Street loves Fintech right now, and Square's mobile payment system has had lots of success so far in the small business sector. However, it is not profitable yet and is not expected to be any time real soon. The mobile payments space is incredibly competitive, and I fully expect to see some of the larger regional banks enter the space in the not-too-distant future as well. There is no margin for error in the pricing of Square stock, but the changing nature of Fintech and possibility for problems in processing and security elevates the risk level of this stock to unacceptable levels, in my opinion. The students at Michigan appear to share my concerns.
The Torpedo List has been very successful at identifying companies with the potential to see a serious decline in their stock price. It makes sense to review the list periodically and avoid or sell the stocks that make the list.