Warnings Signs Of An Overbought Stock, And Determining When It's The Right Time To Buy

by: Edward Vranic, CFA

Editors' Note: This article covers a micro-cap stock. Please be aware of the risks associated with these stocks.

Since pointing out several warning signs with YRC Worldwide (NASDAQ:YRCW) and contending that the stock was due for a significant pullback after it ran to over $35 in price from $7 in a few weeks, the stock has sunk to $18. Their Q2 earnings greatly disappointed and the company retained Credit Suisse - the very same firm which has a $7 stock price target on YRCW - to explore refinancing and recapitalization options. I am no longer bearish on the stock at an $18 stock price, but I will be keenly watching as it could be in for more of a wild ride. As I mentioned before, a refinancing could be good news for the company depending on the terms it receives, however a recapitalization will be extremely dilutive for the stock.

A company which has undergone a recent run that looks to be as unsustainable as YRCW's is BioCryst Pharmaceuticals (NASDAQ:BCRX). In some ways the two companies are similar and in others they are polar opposites. Unlike YRCW, BCRX has a balance sheet in far better working order. They recently completed a secondary offering of 4.6M shares at a price of $4.40 to bring in $20M in cash that provides the company with enough liquidity to early 2015 and gets their balance sheet back to a positive equity position.

However, also unlike YRCW, BCRX's revenues are small and often non-recurring. The stock price sank 13% on August 8th after their Q2 results showed that revenue declined substantially to just $0.8M compared to prior quarters of $3-$5M. BCRX shouldn't be that sensitive to its revenue numbers at this stage as it is a highly speculative company, but the fact that it did shows the volatility of its stock price at the $5+ level.

What BCRX shares with YRCW in terms of their sudden stock price increase is that their recent news doesn't really justify a several-fold increase in market capitalization and much of the speculation is based on "big money" buying in. YRCW first took off in May after they released their Q1 financials. Based on their operating improvement, a stock price increase would have been justified but it moved way too high based on this one quarter of results and the Q2 release shows they are far from being out of the woods. For BCRX, the positive news revolves around recent events for BCX4161 and speculation of an influenza outbreak about to occur in Asia and the possibility of peramivir as a widely-used treatment.

Speculating on the outbreak of the flu is always a gamble. The last few flu outbreaks have been overblown so the chances are any possible outbreak to occur now will be controlled relatively quickly too. Peramivir may or may not play a part in the control of the outbreak, but BCRX is very unlikely to receive any long-term significant revenue stream from it.

BCX4161 has gained momentum for the company for the last few weeks as BCRX recently completed a Phase I trial and the FDA lifted a clinical hold on the drug. Both news events are positive and worthy of a small jump in stock price, but more than a tripling of it in a month is a bit much considering that the Phase I trials were done on healthy volunteers. This means there's no additional proof that it can treat Hereditary Angioedema as intended. An article that very aptly describes the issues with BCRX's pipeline can be seen here.

BCRX shareholders got excited over Felix Baker's recent interest in the secondary offering. The Baker Brothers run a hedge fund focused on the health care sector and participated in the recent placement at $4.40 by purchasing $5M worth of stock. Just like BCRX, YRCW received a speculative lift in its stock price when Marc Lasry purchased shares in it in the $20's. If you review Felix Baker's insider transaction history, you'll see that he bought a lot of Genomic Health (NASDAQ:GHDX) and ACADIA Pharmaceuticals (NASDAQ:ACAD) this year. The ACAD buys were in the $12-$14 range but many of the GHDX buys were made above $36 after opening a position at $27-$29. Considering that the iShares Nasdaq Biotechnology ETF (NASDAQ:IBB) has moved from $140 at the start of the year to over $190 now, these transactions have performed more or less in-line with the overall sector Baker covers.

Just because someone rich decides to invest in a stock doesn't mean they are correct, nor does it mean that their intentions are to see the company maximize shareholder value. In the case of Marc Lasry, his area of expertise is in dealing distressed debt. A share purchase in YRCW may have nothing to do with being bullish on the stock and more to do with securing voting power for a favorable solution to the debtholders. To base your investment decisions on the choices of someone with buying power after a stock has already ran hard is perilous.

Stereotaxis Inc. (NASDAQ:STXS) is a great example of what can go wrong when an investor chases a pumped stock without properly researching their balance sheet or debt covenants. This article was started as STXS was on its way to $10 but the dilutive effect of its financing and the subsequent tank happened faster than what I had expected so I am now talking about the warning signs of STXS retroactively. Referring to its Q1 2013 Quarterly Report, the signs that the company was to undergo a significant dilution were apparent in more than one location. Of particular interest was the Subordinated Convertible Debentures section at the very bottom which stated that the debentures can be converted into 2.5M shares at a price of $3.361 a share. The debenture holders also held warrants which gave them the right to purchase an additional 2.5M shares at the same price. Both the conversion and the exercise of the warrants took place on August 8th in a capital transaction announced by the company.

Referring to the 8-K filed on August 8th, while the capital transactions significantly diluted the stock, they also improved the company's balance sheet. However, the company is still in a negative equity position and has a high cash burn rate so investors should expect another financing to take place, likely within the next 12 months. The price of any future capital injections will depend on the market price of the stock. Given the uncertainty of their financial condition, I don't believe we have seen the bottom for STXS despite the pullback, although I don't feel strongly enough about this to open a bearish position on it.

As part of the loan modification with the lenders as outlined in the 8-K on July 1, nearly 50K warrants exercisable at $1.55 a share were given as part of the deal. One important disclosure within the 8-K for investors to note is that one of the lenders, Sanderling Venture Partners, is an affiliate of Fred A. Middleton, who sold nearly 80K shares at $10.13 after exercising 260K options at a range of $1.98 to $4.10. The proceeds from the sale appears to have been used to exercise the options so investors need to use their own discretion in determining what his motivations are for the sale.

Dynatronics (NASDAQ:DYNT) is another great example of a pumped up stock price gone bad, but unlike YRCW, BCRX and STXS may not have much of a downside at current price levels. After announcing the introduction of the new 25 Series electrotherapy/ultrasound therapy product line on August 5th, a fluff piece in my opinion, the stock quietly rose 16% on less than 100K shares. The next day the stock opened at $4 and rose as high as $7.94 on 3.2M volume, several dozen times more than the average daily volume in the days previous to it and more than the entire share float of the company. As people chased in looking for the next USEC (USU), not surprisingly the stock price sank for the rest of the week.

While many at first may write DYNT off as a pump and dump, taking a look at the state of the company leads me to believe they are quite undervalued. The pump on August 6th may have as much to do with getting new eyes on the stock as it does with market manipulation tactics as it got investors like myself interested. It's important to note that no insider sales have been reported from the August 6th move despite insiders holding 30% of the float. So if the stock was manipulated, it doesn't appear to be for their gain or to provide them a liquidity opportunity. As DYNT is due to release its fiscal year 2013 numbers soon, selling on this insider knowledge would not be something management would want to do anyways. The company states that they have enough liquidity for at least the next 12 months and I couldn't find any significant convertible instruments buried in their reports, so a sudden dilution similar to STXS does not appear to be in the cards either.

Reviewing DYNT's Q3 financials released in May uncovers a company with a $10M market cap at a $4 stock price that makes about $30M a year selling a wide variety of medical equipment. Cynosure (NASDAQ:CYNO), a company with 40 times the market cap of DYNT in the same industry makes only 5 times the sales of DYNT. CYNO recently turned the corner and became profitable in 2012 with strong revenue growth. Its stock price has doubled from the beginning of 2012 as a result. DYNT has the chance to do the same or better as they are on the brink of profitability but with a very low share float and cheap Price to Sales metric. Revenues decreased in Q1 2013 when compared to Q1 2012, but their bottom line improved and the introduction of the new product line could be a catalyst for them to get top-line revenue back to a growth phase.

Referring to my last article, I played down the fact that YRCW has less than a 0.05x Price to Sales metric. There are two differences that make DYNT's P/S of around 0.35x an apt metric to use when determining it's stock is at a good level to buy while for YRCW it is much less appropriate. First, DYNT does not have a burdensome debt level like YRCW. Their current assets cover off all of their liabilities, including their warranty provision. Second, DYNT is pulling bottom line profits, even if they are razor thin. For the past nine months in its fiscal year, it has earned $29K. Small, but at least it's positive and headed in the right direction when compared to a loss of $139K for the nine months ended in fiscal 2012. In anticipation of improved annual financial performance that's due for release and additional investor exposure the volatility of the stock has stimulated, I have purchased a position in DYNT and plan to add to it should the financials turn out to be favorable.

When it comes to overbought stocks, or pump and dumps as they are so unceremoniously called, investors have to take precautions in determining the reasons behind the stock price boost and if it is sustainable. One must always be cautious when buying a stock near the top like YRCW and BCRX and may need to scratch it off their list even on a pullback like in the case of STXS. However, investors shouldn't write off stocks that have been pumped as bad stocks indiscriminately as ones like DYNT can provide them with opportunities for above average returns. Once each investor determines if they can handle the risks associated with companies that have a history of losses and marginally positive working capital positions in exchange for the expectation that their businesses are in the midst of a substantial turnaround to profitability, then these types of stocks often become ones that can sustain in excess of a double or triple in price within several months or a year.

Disclosure: I am long DYNT. 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.

Additional disclosure: In addition to the above disclosures, I hold put options on BCRX.