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As I like to move through my investment theories from a macro to micro perspective this article can be seen as an extension of my recent entry on market bubbles. While that piece addressed the environmental conditions contributing to a series of bubbles, including the current one in technology, this piece looks at investors’ willingness to overpay for the popular stocks of the day. I believe it should be the practice of all investors to buy stocks that offer the greatest potential for returns with the lowest risk. I assert that when investors buy popular stocks they are maximizing risk and dramatically lowering potential returns. These stocks include an upfront "participation premium" just for the right of ownership due to the exaggerated demand for the shares caused by the narrow focus of most money managers and market coverage.

Overfollowed Stocks Are Generally Overpriced

In the short term, the price of stocks has nothing to do with anything but the supply and demand of the available shares. I suppose the short term in some cases can be a long time. Sooner or later a company’s true value will be reflected in its stock price when growth hungry fund managers stop fantasizing about unachievable growth. These managers aren’t creative enough to uncover the greater rewards available with lower risk in lesser followed, newer and smaller technology companies. As well, they would rather all own the same stocks anyway so as never to underperform their peers, thus forcing the prices of a small group of popular stocks even higher. Historically there is significant accumulated data to tell us what stocks and companies are worth. At 8x earnings (P/E) stocks would be considered historically cheap and over 15x earnings (P/E) stocks would be considered historically expensive.

Let’s look at some of the popular stocks of the day. These are stocks that a lot of investors are buying and many professionals are recommending.

Table 1

Bubble Sector Company Price to Earnings Price to Sales Market Valuation
Cloud Computing SalesForce.com (NYSE:CRM) 99 9 $18 billion
Cloud Computing F5 Networks (NASDAQ:FFIV) 33 9 $9.7 billion
Semiconductors Arm Holdings (NASDAQ:ARMH) 65 19 $13 billion
Online Content Netflix (NASDAQ:NFLX) 48 3.6 $11.2 billion

*All numbers taken from Yahoo Finance and based on 2011 expectations

When stocks are overpriced like these, eventually the law of diminishing marginal returns kicks in and so does margin compression and at best you go sideways for 20 years like Microsoft (NASDAQ:MSFT) or much worse you fall precipitously like Research In Motion (RIMM), Crox (NASDAQ:CROX) or Garmin (NASDAQ:GRMN). Those companies too had cheerleaders when the stocks appeared very expensive and I was short all three at much higher levels than today’s prices.

The Justifications

With each overvalued stock comes a series of mostly similar and sometimes new and creative justifications for the inflated price. Here are some of my favorites.

The PEG ratio

The price to earnings ratio divided by the company’s growth rate. The argument is that if this number is close to 1, the stock’s price is properly reflecting the company’s growth even though priced above historically justifiable multiples of everything. Jim Cramer explains that growth managers are willing to pay a PEG of 2 but anything above that is too high for these "fast" growers. The problem with this is that analysts are really bad at predicting long term growth rates and while a company may have a PEG of 1.5 this year, it may become a PEG of 10 by next. Growth is often assumed as infinite and linear when it is actually cyclical and unpredictable.

According to Schwab Research, Arm Holdings (ARMH) has a five year growth rate of 13.5% and a PEG of 7.4, yet many are still recommending it. If the stock dropped to a PEG of 2 it would trade for roughly $8/share. There are so many stocks with financially justifiable growth scenarios why would anyone pay 20x revenues for this or any company? Just because people associate it with a hot growth sector like mobile devices doesn’t mean it is infinitely valuable. ARMH carries a massive "participation premium" that is likely a longer term portfolio performance killer.

You Could Have Said It Was Expensive When It Was 50% Lower

I see this accusation a lot when an overpriced stock continues to rise. You are right. I could have said that it was overpriced and I probably did. There are many problems with this argument. First, just because a stock goes up doesn’t mean it makes sense or was a sound investment. Each stock does not exist in a vacuum. It exists in a market of other stocks and each represents choices for asset allocation. The stocks I own likely also increased and I can explain why I believed that was likely. If you are an investor and you want to make sure that most of your investments are successful, you need to have a consistent and proven selection methodology. Assuming there is someone willing to pay an even higher price for an expensive stock is a risky proposition and I never feel like I am missing out if a stock I don’t own is moving higher.

If you can’t explain why a stock should be priced higher, you shouldn’t own it. If you are a trader, that is a different story. You have in that case constructed a technical argument and you have a precise entry and exit strategy. But the average investor doesn’t part easily with their stocks. Almost every casual investor I know expects their losing investments to "come back" before they are willing to sell them. This is a bad practice. You should always look at your money as finite and stringently monitor that it is distributed as effectively as possible. What you paid for a stock is irrelevant, the best current use for your capital should be your sole decision making criteria. You are much more likely to avoid the predicament of hoping your stocks are going to "come back" by purchasing stocks with historically justifiable valuations and a well constructed analysis of why higher prices are also more than a hopeful outcome.

Creative "New Paradigm" Explanations

Stocks represent ownership in an underlying business and should be valued as such. If you buy stocks as representations of trends or lifestyle choices you are making a mistake. If you are so inclined, use the fervor established by these nonsensical arguments to short stocks, but don’t buy stocks disregarding valuation to participate in trends. Chipotle (NYSE:CMG) is not a lifestyle choice, it is an overpriced restaurant chain. You are not a loser for having a well formulated investment thesis and avoiding overpriced stocks. I seem to find lots of ways to find winning companies without succumbing to that type of propaganda.

Is the mobile device trend really so different from any other recent consumer electronics product introduction? Sony (NYSE:SNE) had been the leader in consumer electronics since the 50’s with the introduction of its transistor radio. After all of Sony’s successful product introductions including the Walkmans and Discmans and TVs and Cameras and Playstation, the company’s current market cap is less than $40 billion. In the heat of the stock market bubble in 2001, SNE reached an all time high valuation of almost $150 billion.

I would argue that it is never different this time, markets are finite and many U.S. technology companies are currently worth significantly more than SNE, one of the greatest consumer electronics company of all time, at the top of a stock market bubble. Asking for higher prices in Apple (NASDAQ:AAPL) or Google (NASDAQ:GOOG) or even Microsoft (MSFT) is pioneering. I don’t understand it. Five hundred million dollar companies become $5 billion companies every few years. Two hundred billion dollar companies never become $2 trillion companies and often become $100 billion companies or less. Again, I like to put my money in the lowest risk highest return scenarios.

Price to Earnings (P/E) Multiples Are Not Useful for Evaluating Growth Stocks in Isolation

The P/E of the "popular stocks" in Table 1 actually understate the overvaluation of these companies. There is already a premium accorded to most public companies. No one in the private sector would ever pay 50x earnings to acquire a large company without some other asset on the balance sheet. Nor would any sane business person pay 20x or even 10x revenues to acquire that company. It is impossible to make a return before death with such a purchase. The stock market is different because the currency is often stock and that is viewed more like casino chips than money.

I believe to find opportunity it is best to formulate a model of what a company will be worth in the future in market valuation terms. This takes a bit of creativity but allows you to look beyond the relatively useless P/E and find opportunity where others don’t see any. Here is what Warren Buffett just said about net income as a valuation tool in his recent annual letter:

"Let’s focus here on a number we omitted, but which many in the media feature above all others: net income. Important though that number may be at most companies, it is almost always meaningless at Berkshire. Regardless of how our businesses might be doing, Charlie and I could – quite legally – cause net income in any given period to be almost any number we would like ...

"If we really thought net income important, we could regularly feed realized gains into it simply because we have a huge amount of unrealized gains upon which to draw. Rest assured, though, that Charlie and I have never sold a security because of the effect a sale would have on the net income we were soon to report. We both have a deep disgust for 'game playing' with numbers, a practice that was rampant throughout corporate America in the 1990s and still persists, though it occurs less frequently and less blatantly than it used to."

Two Low Risk High Return Scenarios in Alternative Energy

Here are two examples of stocks that are positioned to participate in the high growth area of alternative energy by offering LED signage and lighting products to a variety of commercial customers. LED offers the benefits of significantly lower energy consumption and longer life than conventional incandescent lighting. From a signage standpoint it allows advertisers greater flexibility and revenue generation opportunities by allowing signage to become animated and fluid. A report by Pike Research predicts explosive growth for LED lighting, predicting by 2020 LEDs will cover 46 percent of the $4.4 billion U.S. market for lamps in the commercial, industrial and outdoor stationary sectors. That is a huge increase from LED’s current estimated market share of only 2% and that is only the U.S. market, the international opportunity is exponentially larger.

Table 2

Sector Company Price to Earnings Price to Sales Market Valuation
Commercial LED Products Daktronics (NASDAQ:DAKT) 35 1 $479 million
Commercial LED Products LSI Industries (NASDAQ:LYTS) 16 .62 $187 million

*All numbers taken from Yahoo Finance and based on 2011 expectations

While both companies’ P/Es may be considered on the higher side of historical market levels, both are on the low end compared to any of the stocks in table 1. The stocks of these companies are currently depressed. Opportunity lies in the fact that these companies are in a high growth industry in which the benefit to these companies is underestimated. Both trade at or under 1x revenues compared to the unprecedented Price to Sales (P/S) multiples accorded the companies in table 1.

When growth accelerates, these companies should experience margin expansion, driving higher multiples. The companies in table 1 are subject to potentially contracting growth and margin compression, which given the current premium, would drive shares significantly lower. Should the LED industry expand as expected in the coming years, revenues for table 2 companies could double or triple quite easily, potentially driving margin expansion and profit growth at even faster rates. Should this scenario unfold as I outline, the shares of both Daktronics and LSI Industries could easily double or triple. LYTS also offers investors a nice dividend at current prices of 2.5%. If not, multiples are already low and downside is limited. If DAKT and LSI garner favored table 1 type status the upside is only limited by the imaginations of those pioneering investors.

This is how I identify what I view as great risk reward scenarios. My results speak for themselves. You don’t have to overpay for stocks to find great growth and overexpose yourself to risk.

Source: Why Do Investors Continue to Overpay for Popular Stocks?