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  1. Home
  2. / Investing

A Value Investor Looks at the Short Side

At the very least, you should avoid these dangerously overvalued stocks.
By TIM MELVIN Jul 18, 2012 | 01:00 PM EDT
Stocks quotes in this article: APOL, AMZN, ABCO, AVB, SPG

In addition to the collapse of the Mets and Orioles after the All-Star break, the talk of the week around Chez Melvin has been stock selection. We have been going over the record of the past few years with an eye toward opening up a larger money-management practice, and is has been instructional, to say the least.

The practice of buying stocks at a large discount to tangible book value and seeking decent credit scores has been working very well. Of course, someone had to ask how I have done on the short side over the past several years. I don't short-sell a lot and have never been net short and only use options to bet against stocks. On a few occasions I suggest selling, avoiding or shorting certain stocks, so it was interesting to see how these stocks have done.

What I found was that I am pretty good at identifying stocks that have the potential to collapse. I have suggested shorting some stocks such as Green Mountain Coffee Roasters (GMCR), Netflix (NFLX) and of course Apollo Group (APOL) and other for-profit education stocks. I suggested selling Citigroup (C) on the reverse stock split.

The other part of the equation is that as a short-seller I have horrible timing. My overvalued stock selections usually go higher before falling apart. If I were shorting outright instead of using puts and put spreads, they would have carried my carcass off the field by now. However, investors who avoided the stocks I hate would have been saved serious losses when the stocks did eventually run out of earnings and price momentum.

This morning, I sat down to look for stocks that are clearly overvalued and appear to have moved too far too fast. Once again, sitting at the top of my list is Amazon (AMZN). For a long time I refused to suggest selling or shorting this stock, simply because it is a great company. Although it is a great company, I believe its dominance of its market is coming to an end. The Kindle still faces stiff competition, and the Kindle Fire appears to be a bit of a bust, according to my more tech-oriented associates. A move into the smartphone market would be an absolute disaster for Amazon that could send the stock tumbling. At 175x trailing earnings and over 80x times analysts' estimates, the stock it priced for perfection and beyond.

A new name on my list of overvalued stocks is the Advisory Board (ABCO). The company provides consulting and solutions to the healthcare and education industries. Advisory Board is seeing strong growth as both healthcare companies and online education companies have seen a great deal of turmoil. The company appears to offer strong technology and consulting services and has a pretty good niche in the marketplace. However, those positives are not enough in my mind to justify the P/E ratio of 74x or the enterprise-value-to-EBITDA ratio of 26 that the stock currently sports. The market appears to have baked all the good news into the stock -- it has had an 85% price gain in the past year.

As for the larger real estate investment trusts, although they have gone straight up in the aftermath of my suggested call to sell or avoid them, investors should continue to stay away. Stocks such as Avalon Bay (AVB) and Simon Property Group (SPG) have had a great run, but they are priced well in excess of their actual asset value. I don't care how much improvement the retail sector has seen or how strong the fundamentals may appear for rental homes, real estate is worth what it is worth, and stocks like these trade far in excess of what I believe would be a reasonable property valuation.

Over the years I have done OK at identifying stocks that are dangerously overpriced. The caveat here is that my timing is less than impeccable. Quite often the stocks may go higher before the fundamentals reassert control and the shares tumble. Use your own sense of timing and risk management before shorting these stocks. Investors should just avoid owning these candidates for potential permanent capital destruction.

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At the time of publication, Melvin was short APOL.

TAGS: Investing | U.S. Equity | Stocks

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