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As the market continues to move higher, it becomes more and more difficult to find an undervalued stock. Over the past few months, I've made relatively few additions to my long portfolio. The flip side is that it has become easy to find overvalued securities in today's market. There are many, many stocks in today's market that are priced to perfection and beyond. I've focused on stocks which: (1) have unproven business models (2) have seen massive upward movements in the past 12 months and (3) have minimal profitability and (4) have very high valuations. In short (pun intended), I expect these stocks will meaningfully underperform the S&P 500 over a 3 to 5 year horizon. While there are many risks to shorting individual securities, shorting a basket greatly reduces the risk than you end up with a meaningful short position in the next Google (GOOG). I suspect that even a young Google would blush at the valuations the market has awarded the companies mentioned below.

I will focus on three sectors which I believe are overvalued and highlight a few stocks within each sector which I believe to be significantly overvalued. The first sector which is generating nothing but enthusiasm is cloud computing/software-as-a-service (SAAS). Within this category there are many fantastic opportunities for short selling. In addition to selling at nosebleed multiples of revenue, the business model for these companies remains unproven as none of them have generated meaningful profitability on a GAAP basis even though many are now achieving scale. Here is a sampling of opportunities in this space:

Market Cap

Company

Ticker

Share Price

in $ billion*

EV/Revenue (2013e)

P/E

Salesforce.com

CRM

54.40

34.0

8.2

n/a

ServiceNow

NOW

54.08

9.0

23.0

n/a

Netsuite

N

109.19

9.0

21.0

n/a

Tetura

TXTR

43.12

1.1

25.1

n/a

Veeva

VEEV

42.95

6.4

32.0

163

Tableau

DATA

63.60

4.7

17.3

n/a

Workday

WDAY

79.69

14.8

29.7

n/a

*I've used fully diluted market cap which takes into account dilutive options and restricted stock units. This has the most meaningful difference at ServiceNow and Tableau.

As you can see, there is no shortage of very expensive SAAS stocks. Interestingly, other than Salesforce.com and Netsuite, none of these companies were listed prior to 2012. This level of IPO activity always makes me suspicious. I can think of three reasons this group of stocks are so expensive:

1) Investors perceive Salesforce.com as being very successful and that other SAAS companies could be 'the next Salesforce.com' - first off, it is far from clear that these companies will be able to grow revenue at a high rate for as long as Salesforce.com did. Secondly, and more importantly in my view, given that Salesforce.com hasn't generated profitability yet, I wonder if it ever will and I believe that Salesforce itself is massively overvalued. The market assumes that at some point these companies will produce the 30-40% operating margins we see at SAP, Oracle, and Microsoft.

2) Investors over-estimate the rate of change at which the world will move away from on premise solutions sold by Oracle (ORCL), SAP (SAP), IBM (IBM) and Microsoft (MSFT). There are very significant switching costs inherent in these systems and the pace of change will be more moderate than people think - a more in-depth discussion of this 'stickiness' can be found in this SAP discussion.

3) I think that all the talk of platforms and platform related revenues is overdone. There are many reasons why a corporate IT director would be hesitant to invest meaningfully in the third party applications sold through platforms such as Force.com. If the smaller companies providing such applications encounter financial difficulties and are unable to provide services to platform customers, this could cause major problems in a corporate IT environment.

A second area is consumer internet stocks. These companies have had a strong run over the past couple years. Like the SAAS companies, few generate meaningful GAAP net income. Those that do are priced as if they will face very little competition and grow at a very high rate for a sustained period of time. While some of them might, it very unlikely that all of them will and I think a basket trade makes a good deal of sense here. Here are my consumer internet stock shorts:

Market Cap

Company

Ticker

Share Price

in $ billion*

EV/Revenue (2013e)

P/E

Amazon.com

AMZN

332.3

155

2.0

397.6

Angie's List

ANGI

15.45

1

4.0

n/a

Pandora

P

27.42

5.4

7.9

n/a

Netflix

NFLX

322.5

24

5.9

201.6

Yelp

YELP

69.41

4.6

20.0

n/a

Founded in 1994, Amazon is one of the oldest "new economy" stocks with revenue approaching $80 billion. Yet the company is having a difficult time translating its tremendous revenue into profits. While bulls argue that this is because the company is constantly investing in new areas, I'd argue that it operates in highly competitive businesses (general merchandise retail, cloud services, etc.) and leads with price (or cheap/free shipping). While this has allowed it to put the hurt on its competitors, I think it is also putting holding down its margins. Though I think the company could improve profitability overnight by cutting back on growth initiatives and increasing pricing, I also think this would dramatically slow its growth rate and investors would place a much lower multiple on the business. Netflix is a great service for customers but I think the way the shares are priced is crazy (100x 2014's guesstimated earnings)! Also, they are competing with Amazon and for many, many movies Amazon's price is free (with Amazon Prime - members are growing rapidly). Further, studios may change the way they monetize content in a way which is disadvantageous to Netflix.

As for Angie's List, Yelp, and Pandora, I think these companies have fundamentally flawed business models. While it looks like the market is starting to worry about Angie's List, there is nothing but enthusiasm for Yelp. While Yelp has fewer obvious faults in its model than Angie, the company doesn't earn a profit and sells for more than 20x revenue. Pandora is another business which has yet to demonstrate it is a business (based on their financial history Pandora.org might be a more appropriate website). Given the high variable costs associated with playing each song and the high level of competition in the streaming radio sector (which makes it difficult to raise prices or add more airtime), Pandora is between a rock and a hard place though it sells at the price of a firmly entrenched monopoly.

The third and final area I will focus on is the biotech space. We've seen 30 biotech IPOs thus far in 2013 and prices of new and more established companies have soared. While there is widespread enthusiasm about the potential for new blockbusters from the group, the fact is that 84% of drugs never receive Phase III approval from the FDA. Also, eager capital markets are flooding the sector with money which means we are likely to see more competition for patients. None of this is good for business. Because these companies tend to be pipeline stories, most trade at gigantic multiples of revenue. Trying to pick which companies to short is too hard for me frankly. The list of unknowns is huge - will the drug get approved? Will it be a little monopoly or will competitors have drugs approved as well? How will it be priced? However, given the exuberance in biotech share prices, I would be remiss if I couldn't participate in their eventual decline. I've chosen to short the sector by using an ETF, SPDR S&P Biotech ETF (XBI). This allows me to short 59 biotech companies (largest position size is sub 3%) without the hassle of doing a tremendous amount of research on the sector.

Shorting a basket of the above stocks should help (1) protect you in a market correction which seems likely given the poor economy and market manipulation by the Fed - in past corrections, high multiple stocks have tended to fall the furthest (2) avoid the pitfall of having a large short position in any single security and (3) should generate a positive overall absolute return over the medium term given the outlandish valuations of these securities and unproven business models (in some cases). Happy shorting!

Source: The Market Has Been Strong For Too Long - Here's How To Protect Against A Fall