3 Great Growth Stocks That Might Not Be Worth Holding Now

 |  Includes: LULU, NFLX, OPEN
by: Sebastien Buttet

by Sebastien Buttet

Peter Lynch's track record as a stock picker and fund manager is nothing short of spectacular. During his tenure at Fidelity Investments between 1977 and 1990, his Magellan Fund beat the S&P 500 in all but two years. The fund returned an annual average of 29% which compounded over thirteen years and led to a 28-fold increase in value. A mere $35,714 invested in the fund when it was launched was worth $1 million thirteen years later.

After retiring from managing the fund, Lynch became an acclaimed author when he laid down his investment philosophy in the New-York Times best-seller "One up on Wall Street." Perhaps his most well-known principle is that retail investors have an edge over professional fund managers because they get first-hand information on new products and services that Wall Street firms wait months for analysts to come up with.

Lynch also coined the term "ten-bagger" to describe a stock that returns ten times the money originally invested. Numerous examples of ten, twenty, and even forty-baggers are provided in his books including Dunkin Donuts, Wal-Mart (WMT), Home Depot (HD), and Taco Bell.

We review three stocks in today's markets that closely fit Lynch's investment criteria of "invest in what you know".

Netflix: (NASDAQ:NFLX): With more than 20 million members in the United States and Canada, Netflix, Inc. is the world’s leading Internet subscription service for enjoying movies and TV shows. For $7.99 a month, Netflix members can instantly watch unlimited movies and TV episodes streamed over the Internet to PCs, Macs and TVs. Among the large and expanding base of devices streaming from Netflix are Microsoft’s (NASDAQ:MSFT) Xbox 360, Nintendo’s (OTCPK:NTDOY) Wii and Sony’s (NYSE:SNE) PS3 consoles; an array of Blu-ray disc players, Internet-connected TVs, home theater systems, digital video recorders and Internet video players; Apple’s (NASDAQ:AAPL) iPhone, iPad and iPod touch, as well as Apple TV and Google (NASDAQ:GOOG) TV. In all, more than 200 devices that stream from Netflix are available in the U.S. and a growing number are available in Canada. The company was founded in 1997 and is headquartered in Los Gatos, California.

Open Table (OPEN): OpenTable, Inc., together with its subsidiaries, provides restaurant reservation solutions in the United States, Canada, Mexico, Europe, and Asia. It offers solutions that form an online network connecting reservation-taking restaurants and people who dine at those restaurants. The company provides an electronic reservation book (ERB), an integrated software and hardware solution that computerizes restaurant host-stand operations. The ERB enhances various functions and processes for restaurants, including reservation and table management, guest recognition, and email marketing. The company also operates opentable.com, a restaurant reservation website that enables diners to find, choose, and book tables at restaurants on the OpenTable network in real time. OpenTable was founded in 1998 and is headquartered in San Francisco, California.

Lululemon Athletica (LULU): Lululemon athletica inc. is a designer and retailer of technical athletic apparel primarily in North America. Its yoga-inspired apparel is marketed under the Lululemon Athletica brand name. The company offers a line of apparel and accessories, including fitness pants, shorts, tops and jackets designed for athletic pursuits such as yoga, running and general fitness. As of January 31, 2010, its branded apparel was principally sold through 124 stores that are primarily located in Canada and the United States. As of January 31, 2010, its retail footprint included 45 stores in Canada, 70 stores in the United States and nine franchise stores in Australia.

Note that the mere knowledge of a good product or service is not a recommendation to buy stocks. The great insight of Peter Lynch was to buy the stock before the big boys (read institutional investors) do. Many of us already subscribed to Netflix's services years ago (I started to subscribe in the early 2000s), made a reservation at a restaurant through Open Table or shopped for yoga apparel at a Lululemon store. However, the horse has already left the barn as all three stocks have already had huge run-ups. Netflix for example was a 14-bagger since the stock made a low of $17.90 on October 27, 2008.

In Table 1 below, we present selected financial information about our three stocks.

Table 1 - Descriptive Statistics
Stocks Market Cap (in Billions) 12-Month Return 12-Month Trailing P/E Proj. Earnings Growth Short Interest Inst. Ownership
NFLX $12.94 230% 82.7 47% 23.15% 89.17%
OPEN $2.6 205% 183.3 56% 21.93% 94.14%
LULU $5.0 135% 55.2 57% 12.47% 94.96%
Click to enlarge

All three stocks are mid-cap, have largely out-performed the S&P 500 in 2010, and trade at very high P/E ratio due to the rapid projected earning growth rate for next year. Note that NFLX and OPEN also trade at very high PEG ratio of 1.7 and 3.26 - PEG is equal to the P/E ratio divided by the earnings growth rate.

Two important factors propelled the stocks higher in 2010 above and beyond rapid business expansion (and sent unsuccessful short-sellers to the cleaner): The high short interest as a percentage of the float; and the accommodative monetary policy at the Fed. The Fed started to signal a change in monetary policy before the year end. However. Minneapolis' Fed president Narayana Kocherlakota, a hawk and voting member on the FOMC, warned that the Fed funds rate could increase by 75 basis percentage points before year end and be as high as 2% in 2012.

As the Fed withdraws liquidity and borrowing costs increase, we urge investors to reconsider their thesis for owning these three stocks and carefully review the company's fundamentals. If markets correct following the Fed's tightening, we suspect that all three will be hit hard given their gravity-defying valuations. In addition, these stocks are widely held by professional money managers as shown in the last column of Table 1. Selling pressure could be quite intense and trigger large precipitous drops in stock prices if money managers decide to ring the register at the same time.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.