The Dangers Of Shorting Nose-Bleed Valuations

Includes: AMZN, CRM, LNKD
by: Karthikeyan Srinivasan Harith

Various articles have been written by my fellow Seeking Alpha authors making a case to short stocks with nosebleed valuations - some prominent examples come to mind: LinkedIn (NYSE:LNKD), Amazon (NASDAQ:AMZN), and (NYSE:CRM). These stocks have breached traditional valuation metrics and a short thesis built on these metrics could mislead you in the short run. I have written this article aimed at any new traders who might be led to believe that taking short positions based on the constant influx of "short ideas" articles in these stocks could give them profits soon.

Let us take the example of LinkedIn. Some fact checks first:

Market Capitalization $ 16.58B
P/E Ratio (TTM) 808
Price / Sales 17.05
Price/Cash per Share 163.44
Source: Reuters 2012 2011 2010 2009 2008 2007
Revenue (MN) 972.31 522.19 243.1 120.13 78.77 32.49
% Growth 86% 115% 102% 53% 142%
Net Income Before Tax 57.11 22.94 18.97 -3.12 -4.23 0.34
As a % of Revenues 6% 4% 8% -3% -5% 1%

LNKD has performed exceedingly well over the recent past with an earnings beat in every quarter since its IPO. These current valuations suggest that LNKD has to sustain or grow faster than these rates for a few years to come. You can read articles on why people think the company is overvalued here and here.

So does that mean you short the stock? My take is no. Due to the high costs of shorting I generally short a stock only if I believe:

a. The company's business model is fundamentally flawed. The company is not growing, cannot retain its customers and has lost its competitive edge.

b. The company is a fraud, and is going to be shut down soon by authorities.

While the analysis that LNKD is overvalued might be correct, it might be a long time before you see a catalyst that would turn it south. When you are short time is not on your side. LNKD has proven that it can monetize its growing user base with growing ARPU as well as a growth in the number of users itself. It has a fundamentally sound business plan and the retail craze around the stock has supported a strong uptrend in the price. Will you be able to sleep at night knowing that you are short a stock that grows in revenues 100% a year, regardless of the valuation?

Another excellent example in this category is Amazon. You will find many articles on this website screaming of a short thesis. AMZN has shown strong uptrends recently and any dip is seen as a buying opportunity and the stock bounces back with more vigor on each dip. (and the SaaS industry in general) has also left me scratching my head with an undefined P/E and yet trading at an astronomical 8.8x price/sales. The theory goes that CRM is heavily institutionally supported leaving many shorts frustrated. If you had shorted AMZN, CRM or LNKD any time in the recent past - you would be deep underwater today.

For a stock to see precipitous falls that will make your shorts consistently profitable - you need a mix of bad news acting as a catalyst and market timing which will lead to human emotion driving the stock further lower.

Conclusion : If you are new to the game of shorting and are looking for short picks, be careful in picking your shorts purely on the basis that the stock is overvalued. When the bear markets steps in, you will find that these stocks are probably the first and furthest ones to fall. In bull markets, expect to find big jumps on even the smallest positive news. As it is often said - there is a time to buy, a time to sell and a time to go fishing. As far as these stocks are concerned - in this bull market environment, now is the time to go fishing.

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.