" I never buy at the bottom and I always sell too soon." --Baron Nathan Rothchild's success formula (London Financier, 1777-1836)
There's a statement to ponder. Baron Rothchild apparently didn't try to find "bottoms," and he was willing to exit an investment "too soon." He was well-connected and "in the know." He was the "smart money" of his day.
Another fine point of trading is to look at our stock portfolio in a celebratory way, but with the emphasis on finding stocks that may have gone up too far and too fast. They've become "expensive."
A good example is Whole Foods Market (NASDAQ:WFM). It's a terrific growth story, and in the last quarter (ending September 30th) it reported year-over-year quarterly earnings growth of almost 50%. It also attained quarterly revenue growth of 24%.
These are outstanding quarterly results for any company, but especially for one that's a glorified supermarket with an expanded product line. If you've shopped at WFM, you know you're going to pay more than you would at a standard supermarket, but you feel it's worth it because you're buying products that are organic or "natural."
Whole Foods has total cash (most-recent-quarter) of $1.22 billion and levered free cash flow of over $382 million. Its operating cash flow (trailing-twelve-months) is an impressive $920 million, with only $24 million in total debt (mrq).
Here's a one-year chart of WFM showing its 52-week high price of $101.86, the 200-day Simple Moving Average and the Relative Strength Indicator (RSI).
The chart looks almost picture perfect, and the popular RSI is signaling that it's close to being oversold. The share price is down almost 10% from the high.
The RSI, or Relative Strength Indicator, is a momentum oscillator that compares the strength of gains against the strength of losses over a given period. RSI always ranges between 0 and 100. Values below 30 and above 70 are typically taken as oversold and overbought, respectively.
A strengthening RSI indicates that gains are tending to dominate losses. Once the RSI climbs above 70, however, the sustainability of the gains is called into question. WFM looks oversold, and technically is oversold, but there's a contradiction of sorts.
WFM is selling for 36 times current earnings and almost 27 times forward (1-year) earnings. Also, its Price-to-Earnings-to Growth ratio ("PEG ratio") is 1.81. This tells me that the market has very high expectations for the company's rate of growth.
Experience teaches us that very high expectations often lead to very big disappointments. If one or more analysts or the company itself were to lower its guidance for the current quarter, watch out below!
If you're planning on buying some WFM, or if you already own shares and have experienced some significant gains, I have two suggestions for you. Potential investors may want to watch the stock or buy fewer shares than they'd normally purchase. Those who own the stock may want to sell at least 50% to protect gains, or use a trailing stop loss order that the market-makers can't see.
Smart investors are disciplined when it comes to position sizing. This helps to minimize risk and guard against unacceptable losses. If WFM were to experience the same kind of dramatic correction that Chipotle Mexican Grill (NYSE:CMG) did, you'd be thankful that you didn't own an inappropriate position size.
The chart below of CMG illustrates what can suddenly happen to a stock that was trending higher and had experienced powerful upside momentum.
The chart illustrates how a stock can "fall off a cliff" and how its RSI can plunge down to near zero. With today's volatile markets and economic conditions, an ounce of prevention is worth a pound of cure.
Another company whose stock has a premium value, yet is well worth watching is Dunkin'Brands (NASDAQ:DNKN). Along with its subsidiaries, it owns, operates, and franchises quick service restaurants under the Dunkin Donuts and Baskin-Robbins brands worldwide. Let's take a peek at its one-year chart and look for some insights.
DNKN is trading below its 200-day SMA and its RSI has moved downward, closer to the level where it has mounted a rally in the past. The stock is trading at nose-bleed levels on its current PE ratio of over 76. Its forward (one-year) PE ratio is a more modest 20.
The PEG ratio for DNKN is a better valuation than WFM at 1.41. If you like explosive quarterly growth, its year-over-year quarterly earnings-per-share (EPS) growth blew away the competition at 298%. Its quarterly revenue growth was up only 5%, but its operating margin approached 33%.
Dunkin's 2% dividend represents a 64% payout ratio of the company's earnings, but if its growth rate continues to soar at anywhere near recent levels, that should improve. Starbucks (NASDAQ:SBUX) also has a forward PE ratio of 20 and its PEG ratio is only 1.32.
But SBUX's operating margin as of September 30, 2012 is only 13.43%, and its year-over-year quarterly EPS growth was nearly flat at 0.10%. Starbucks' market cap is 11 times bigger than Dunkin's, and that signals that DNKN has a long way to grow before it catches up with its seasoned competitor.
While looking for the next Starbucks, you might consider a company whose stock has just received a big boost. Green Mountain Coffee Roasters (NASDAQ:GMCR), an emerging competitor in specialty coffee and coffee makers, announced on November 8th a partnership with Luigi Lavazza SpA, the symbol of Italian coffee around the world.
GMCR will begin using the Keurig® Rivo™ Cappuccino and Latte System in its stores. "The new Keurig® Rivo™ System combines the legendary simplicity of Keurig® single cup technology with the authenticity of Italy's favorite coffee, Lavazza®, and marks GMCR's entrance into the espresso, cappuccino and latte brewer category", the company's latest press release proclaimed.
Shares of GMCR leaped almost 6% on Monday, November 12th. With its $3.91 billion market cap and a very modest forward PE ratio of less than 11, this could be an auspicious time to begin accumulating shares on pull-backs.
In its most recent quarter ending June 23rd, the company reported quarterly EPS growth of over 30% and revenue growth of 21%. Its next earnings release will be on November 27th, so keep some cash on the sidelines in case the company disappoints.
The one-year chart indicates that GMCR might be moving closer to an explosive rebound... or not. It also illustrates how a stock's price can suddenly plunge and take a serious pounding.
Green Mountain's PEG ratio is a suspiciously low 0.52, which accurately suggests that the stock may be very undervalued. Proceed with caution and thorough due diligence.
The moral of the story with richly valued stocks like WFM is that perhaps the downside risk isn't worth the small upside potential. Look for companies whose shares have either been underestimated or have stumbled hard, yet show outstanding potential for recovery and exciting returns.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.