With the fiscal cliff approaching, and no sign that Congress will be able to agree on a solution before January 1, many investors are understandably skittish. Jon Najarian, a frequent guest on CNBC's Fast Money, announced this week that he has exited all of his positions. He stated that there was no reason to be long or short given the risks in the market today. However, while this is an understandable strategy, I still believe there are good value plays in the market. I am not willing to move to an all-cash portfolio, because I would risk missing out on upside for stocks that I believe are trading well below their intrinsic value.
As a result, I am following a move to absolute return strategies rather than exiting the market entirely. Adding some short positions to your portfolio gives you a chance to profit regardless of which way the market moves. Any good short candidate should be an overvalued stock that is likely to correct lower eventually. Right now, I am particularly looking at companies with businesses tied to discretionary spending. The uncertainty associated with the fiscal cliff is likely to pressure discretionary spending (by consumers and businesses alike) in early 2013. Indeed, the most recent consumer confidence reading showed an unexpected drop. The following four stocks are good short candidates at this point, based on my criteria.
1) Amazon.com (NASDAQ:AMZN): Over the past six weeks, Amazon moved back towards its all-time high of $264.11, peaking above $260 the week before Christmas. The stock has since pulled back by 5%, but there is significant downside ahead. Amazon.com continues to trade for more than 100X forward earnings estimates. If consumers cut back on discretionary spending next year, estimates of Amazon's revenue growth could take a big hit, leading to multiple contraction. While the company is benefiting from the growth of e-commerce as a whole, international sales growth has been lagging domestic sales growth recently, due to the weak European economy. This shows that the company is not immune to macroeconomic pressure. Amazon's management can explain away low profitability as the result of investments in content and distribution infrastructure. A slowdown in revenue growth, on the other hand, could cause the stock to drop by as much as 50%.
2) Dillards (NYSE:DDS): As I explained in an earlier article, investors seem to have an overly rosy view of department store chain Dillards. The company has done an admirable job of recovering from the recession and right-sizing its store base, which has led to record profitability this year.
(Courtesy of YCharts)
However, the positive trends are unlikely to last. Slower consumer spending due to the fiscal cliff is likely to pressure sales and earnings next year. Moreover, Dillard's has benefited significantly from the stumbles of other department stores (particularly J.C. Penney (NYSE:JCP)) over the past year. Stronger competition going forward could chip away at Dillards' margins and market share. Furthermore, the retail sector as a whole will be pressured during the holiday season next year because there will be fewer shopping days between Thanksgiving and Christmas, and also because the current fiscal year includes an extra week at the end of January. As a result, I expect EPS to drop next year. With Dillard's trading for almost 13X FY12 earnings, the stock appears overvalued relative to competitors.
3) United Continental Holdings (NYSE:UAL): United Continental, the parent of United Airlines, has seen earnings under severe pressure this year, due to merger integration difficulties. While I had previously been bullish on the company's prospects, I threw in the towel several months ago, and now see the stock as a good short candidate at current levels of around $23. As I wrote recently, pay raises resulting from labor integration agreements will cause sharp unit cost increases next year. According to recently issued guidance, United's non-fuel unit costs will increase by approximately 6% this quarter. Accordingly, analyst estimates for Q4 EPS will need to come down significantly. While analysts are currently expecting a loss of 25 cents per share, I believe a loss of 70-80 cents per share is more likely. While United also reported an increase in booked load factors for the next six weeks, this does not have a clear relationship to revenue trends. Given that network airlines have historically been vulnerable to economic weakness, United is unlikely to generate the mid-high single digit improvement in unit revenue that it needs to meet analyst expectations for next year. United trades at a premium to peers, and it could therefore fall the hardest if a weak economy undermines revenue growth.
4) Netflix (NASDAQ:NFLX): Netflix is a similar stock to Amazon.com at this point in time. Neither company makes much money, and so high valuations are based on investors' hopes for strong growth combined with margin improvements over time. Netflix trades for more than 200X forward earnings estimates. This is particularly unusual because the company is posting revenue growth only a little above 10%. Netflix has nearly saturated the North American market for streaming video, and so bulls are relying upon strong international growth and margin expansion to lift the stock. However, the streaming video model has razor thin margins compared to the dying DVD business. As the DVD subscriber base continues to shrink, Netflix will have a hard time replacing the lost profits. The company is currently hovering on the edge of profitability - even slight belt-tightening by consumers could push Netflix back to a net loss. Management has stated that it will wait until the company is "solidly profitable" before entering new international markets. If Netflix seems on track for an annual loss in FY13, investors will probably become a lot more skeptical of CEO Reed Hastings' growth plans. The stock could then see severe multiple contraction from current levels.
Each of these four stocks is a good short candidate for the reasons outlined above. I see minimal upside for these stocks over the next year, even if Congress fixes the fiscal cliff more quickly than expected. By contrast, if the stock market drops sharply next year, these stocks are likely to be particularly hard hit, which could offset losses elsewhere in your portfolio. I have therefore opened short positions in three of these stocks to protect the rest of my portfolio heading into 2013.
Additional disclosure: I may initiate a short position in NFLX over the next 72 hours.