As MIT Professor Andrew Lo points out in his Adaptive Market Hypothesis, the single-most important mission of a long-term investor is to survive until the long term. It is critical to your long-term success to avoid situations that may cause a permanent loss of capital. Investing in stocks that are more like betting slips in a daily popularity contest as opposed to sound investments based on the relationship of price-to-business value is the surest path to wealth destruction. When these stocks collapse there is little to no chance that the price will recover to its former lofty levels in anything approaching a reasonable amount of time.
To identify situations that leave investors exposed to unrecoverable losses I simply reversed Wednesday's criteria for potential rebound candidates. I ran a screen looking for companies that had had a terrific run in 2013 but had low Piotroski F-scores, indicating a worsening fundamental and financial condition. Plus, I want to find those ever-overvalued companies where the insiders were bailing out of the shares and locking up gains. The result is a list of stocks that are potentially toxic to your long-term returns and should be avoided or sold. They are not necessarily toxic companies, but simply companies where business is just OK and the stock is too high relative to the value of the company.
Interactive Brokers (IBKR) is a great example of this kind of situation. The electronic broker has recovered nicely in the past year as shares have gained about 80%. Many of the short-term, active traders I know use the service and rave about the company, but it's not a good stock with the shares trading at 28x earnings. The F-score is just 3, indicating that the financial statements show deteriorating conditions and a high probability the stock underperforms. Insiders must think so too, as there has been heavy selling by officers and directors for several months. Long-term investors are probably wise to take the hint and join them.
Deckers Outdoor (DECK) is a decent company with good products. My wife and daughter love Uggs and Sanuks, and we have a bunch of the products in our home. But the footwear maker's stock has appreciated to the point that it is not even vaguely related to the value of the business. The stock trades at almost 30x earnings and the F-score is just 5, so the operating and financial condition of the company is just mediocre right now. Six different insiders have sold part of their holdings in the past three months, and that kind of cluster selling is not a good sign for future progress in the stock price. The stock has doubled in the past year and it is probably time to let the shares go. I certainly would not advise buying at this level.
LinkedIn (LNKD) is another example of a good company with a bad stock price. The social media and networking company has had a solid run this year and the stock price has more than doubled. But popularity alone cannot disguise the fact that the fundamentals are not as solid as they could be. The F-score is just 4, and the stock is nowhere near cheap. The stock is currently trading hands at more than 700x trailing earnings and has a triple-digit multiple of the always highly accurate analyst estimates for 2014. The stock is one missed earnings report away for becoming the poster child for a permanent loss of capital.
Balchem (BCPC) has ridden the global food production story and fracking wave to an impressive year. Shares of the chemical company have shot up by almost 60% this year. There is a lot going right for this company but the stock is priced for perfection at 40x earnings. The F-score is just 4, which indicates there may well be short-term difficulties for the company and its stock price. Insiders seem to think this may be the case as they have been heavy sellers of the stock in recent months.
There are many examples of decent companies selling at ridiculous prices in the stock market. Avoiding stocks that trade at very high multiple earnings and are showing signs of weakness in their F-scores can help you to avoid catastrophic losses in your portfolio.