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by Sebastien Buttet.

As the stock market starts discounting the end of the Fed's QE2 coming in June, along with possible spending cuts and austerity programs in Washington, investors should steer clear of momentum stocks such as Netflix (NASDAQ:NFLX), Lululemon Athletica (NASDAQ:LULU) or Open Table (NASDAQ:OPEN), which could rapidly lose their mojo and suffer sharp declines in market prices.

In a previous commentary ("3 High Growth Stocks That We Would Not Buy Right Now") we recommended against initiating new positions in the aforementioned stocks and said that if investors have long-term gains, they should seriously consider ringing the register. For more aggressive investors who hold short positions, we propose a comparative analysis of OPEN vs. NFLX using insights gained from applying Joel Greenblatt's magic formula, only in reverse.

The magic formula investing was developed by investment guru and Gotham Capital's fund manager Joel Greenblatt and is brilliantly presented in The Little Book That Still Beats the Market. It is a very simple quantitative scheme that uses return on invested capital (ROIC) and earnings yield (the inverse of the P/E ratio) to rank a stock's buying appeal. A high ROIC shows that the company has a profitable business model. The earnings yield tells how expensive the stock is, in particular when compared with the 10-year Treasury rate. Good businesses that sell for cheap (or equivalently have a high earnings yield) rank high on the buying list constructed by following the magic formula.

The magic formula has produced very good investment returns over the years: During the 1988-2004 period, a hypothetical portfolio of stocks designed and rebalanced according to the magic formula would have produced average annual pre-tax returns of 30.8% versus 12.4% for the S&P 500 Index.

In Table 1 below, we present descriptive statistics for OPEN and NFLX including ROIC and earnings yield. These two companies have a lot in common:

  1. Their market capitalization has more than tripled in value in the last 12 months.
  2. Both stocks command very high market multiple compared to the S&P 500 index (83 for NFLX vs 184 for OPEN), in part due to the high projected earnings growth rate of 47% for NFLX and 56% for OPEN.
  3. Both stocks are heavily shorted with more than 20% of the float being held by short-sellers.

Table 1 - Descriptive Statistics:

Stocks Market Cap (in Billions) 12-Month Return 12-Month Trailing P/E Proj. Earnings Growth PEG Short Interest Earnings Yield ROIC ROE
NFLX $12.94 230% 82.7 47% 1.75 23.15% 1.2% 65.75% 36.80%
OPEN $2.6 205% 183.3 56% 3.27 21.93% 0.5% 12.76% 16.04%

In terms of P/E or the PEG ratio (the ratio of P/E to earnings growth rate), both NFLX and OPEN are expensive stocks and OPEN is the more expensive one of the two. The earning yield for NFLX is 1.2% versus 0.5% for OPEN, a meager yield compared to the 3.5% rate on 10-year Treasury.

But more importantly, NFLX's ROIC and ROE is much higher than that of OPEN. A dollar reinvested in NFLX's business yields an additional 66 cents of (retained) earnings one year later. In comparison, each dollar reinvested in OPEN only produces 13 cents in earnings the following year. The higher ROIC and ROE for NFLX implies that the total capital for NFLX and thus its earnings will keep growing at a high rate over time. In contrast, equity capital for OPEN will only grow at 12% per year.

We recommend that investors stay away from OPEN and NFLX as both stocks could be hit hard if the market enters a correction phase. However, for those investors who believe that OPEN and NFLX are too expensive and wish to initiate short positions, we believe that OPEN is a better short as the company's business fundamentals are weaker than that of NFLX. In Buffett's parlance, NFLX's moat is deeper than OPEN's moat.

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

Source: OpenTable, Netflix: Steer Clear of Momentum Stocks