This Market Requires Caution and Patience

by: Steven Bulwa

Our New Technology Portfolio has been doing terrifically in the bullish environment of the last 12 months. Three of the portfolio’s top holdings were acquired during this period, two at 100% premiums and one at a 60% premium. Many other holdings are up 50% or more. I have spent years developing strategies for identifying the best new technology trends and participating companies. I work with top members of the scientific community to validate these investments themes. Recent successes include:

  • Crucell (NASDAQ:CRXL) a longtime holding and pioneer in cell line technology acquired by Johnson & Johnson (NYSE:JNJ) at a 60% premium to the previous day’s close;
  • Abraxis (ABII) a player in nanotechnology formulations of chemotherapy agents for improved delivery and tolerance acquired by Celgene (NASDAQ:CELG) at a 100% premium to the recommendation price; and
  • Nighthawk (NHWK) a provider of outsourced X-ray reads weeks after recommendation for 100% premium from the previous day’s close by competitor VRAD.

While this performance is satisfying and encouraging, market participants are currently too giddy for me to remain aggressively bullish. Timing purchases and aggression is critical to outsized gains. I enjoy buying other people’s desperation and it is a very profitable strategy. Buy low, sell high. Right now, people are overpaying for momentum names. Favorites like Chipotle (NYSE:CMG), Netflix (NASDAQ:NFLX), Apple (NASDAQ:AAPL) and Amazon (NASDAQ:AMZN) are all ridiculously overpriced.

It is vital to your portfolio to buy stocks with favorable risk/reward portfolios. When investors are paying unprecedented valuations for large companies, they are dramatically turning the risk/reward equation towards risk. I believe this is taking unnecessary risk. This type of “pioneering” or hoping an individual company will continue to trade at higher valuations than peers is the game of momentum players and technicians. There is no room for this in a good long term growth portfolio. See our report “Bigger is not better”.

Chipotle (CMG) is one such overpriced stock. I can’t find any $5 billion or greater market cap restaurant stocks trading 4x revs and 50x earnings. This company needs everything possible to go more than right for the stock to continue higher. I am more inclined to decide that markets irrational exuberance for short term performance pushed CMG far too high and the stock is much more likely to head lower from here based on historical evidence. I don’t bet on rarely seen events, I bet on high probability outcomes. I am establishing a short position in the name.

Restaurant stock valuation comparison (current year 2010 estimates)

Revenues P/E P/S Market Cap
Chipotle (CMG) $1.8 bil 50x 3.8 $6.4 billion
Yum (NYSE:YUM) $11 bil 20x 2 $23 billion
Darden (NYSE:DRI) $7.5 bil 15 <1 $6.5 billion
Brinkers (NYSE:EAT) $2.7 bil 15 <1 $2.1 billion
Click to enlarge

This chart shows CMG trades at the extreme high end of valuation relative to its more diversified peers. This makes the company almost impossible to consider as an acquisition candidate for another company. It also makes maintaining these high valuation metrics extremely unlikely historically. In their current earnings report, the company indicated that same store growth would fall to single digits in the coming years. I recommend selling or shorting CMG. I will recommend buying equities where growth prospects are underestimated and valuations are therefore too low. In these situations there are opportunities for stock appreciation – either acquisition becomes a possibility, or a return to market multiple valuation would bring stock appreciation. I have four great opportunities I am in investing in right now. Stocks that can double and triple without a valuation leap of faith.

High flying, low quality semiconductor names like Cirrus Logic (NASDAQ:CRUS), Triquent (TQNT), Skyworks (NASDAQ:SWKS) and RF Microdevices (RFMD) tell me market participants have learned little or nothing about the cyclical nature of semiconductors. We are due for a serious correction and if you are prepared, you can make a lot of money buying my stock recommendations filtered from lists of over 500 new technology stocks.

There are still a group of stocks I favor in areas like biometric network security, medical technologies, alternative energy and nanotechnology. Given market conditions, I am lightening up on all but a few names in these spaces and starting to short the semiconductor index and specific high flying momentum names. When the correction comes, we are prepared to pounce on names that are underfollowed and underappreciated in areas that include alternative energy, medical technologies, nanotechnology, advanced manufacture, biotechnology, and network communication, internet and security. Are you prepared?

Disclosure: Short CMG