Over the weekend, I had a chance to talk to some of my trading and investment friends and eventually the topic turned to all the old market hands expressing dismay and concern about the market. In recent weeks, we have seen Carl Icahn, Sam Zell and even once raging bull David Tepper express worry about the valuation and price level of the stock market. While it is true that Mr. Zell and Mr. Icahn started expressing their concerns a year ago, it is also fair to say that the market has not done very much over that time.
While I never make predictions about market direction, if I had Doug Kass' proverbial gun to my head, I would confess I am closer to the concerns of the grizzled veterans than I am to the "going up forever because the economy is so bad the Fed cannot raise rates" crowd. While I agree that the economy is far too weak for significant rate increases, I think that eventually companies will have a hard time financially engineering profits, and market levels will adjust to lowered earnings expectations. Most of the folks I talked to this weekend had the same general danger zone sentiment.
The conversation turned to the subject of what not to own in such an environment. My first thought is that I do not want to own stocks that trade at high valuations and have any sort of balance sheet weakness. If we start seeing serious selling, it will be the first stocks that the institutions throw out the window. Even those funds with a fully invested mandate or philosophy are to adjust their portfolios in favor of quality to preserve as much capital as possible, and companies with valuation and financial risk are going to enthusiastically be sold at the first sign of trouble.
Yesterday -- while watching the Ravens season pretty much come to the end for all practical purposes -- I sat down and ran a screen looking for overvalued high-risk companies investors should avoid and traders might want to watch for opportunities to short. I looked for companies with high EV/EBIT ratios, high price-to-book multiples, with high debt levels and low Altman Z-scores. The screens results give ups a list of possible time bombs.
At the top of the list is a Chinese company Ctrip.com (CTRP). I generally avoid Chinese stocks as a rule, but the valuation and balance sheet risk of this company would give me reason for pause even if I was a raging China bull. The company provides travel services such as packaged tours, hotel accommodations and corporate travel services within China. It is not profitable right now and is trading at 58x next year's anticipated profits. It has a debt-to-equity ratio of 2.3 and the Z-score is a shaky 1.6. While the earnings predictions for next year are enthusiastic, this is the type of stock that has high low up potential in a bad market. Add in the China factor, and this appears to be a very dangerous stock to hold.
I am a big fan of the Clean Harbors (CLH) collection of businesses, but not so much the stock's valuation and balance sheet. The company provides hazardous material management services, industrial services for the chemical, petroleum, pulp and paper industries. It also provides environmental clean-up services and owns the Safety Kleen oil collection and parts washing business. The stock trades at 15x book value and the EV/EBIT ratio is 47.4, so it is impossible to make a case that the stock is cheap or even fairly valued at this level. The debt-to-equity level of 1.2 is not horrible, but when combined with the 1.99 Z-score, the balnce sheet is a little weak for my taste. I love the collection of businesses, but there is simply no valid reason to consider buying or owning the stock at this level.
I am going to spend some more time thinking about what not to own in the current market. One of the tricks to surviving a bear market is to not go into owning all the stocks that lead the way lower when disaster strikes. Companies with high valuations and shaky balance sheets are more likely to feel the claws of the bear more deeply than stronger companies trading at more reasonable levels.