4 Cheap Growth Companies and 4 Overvalued Short Candidates for Pairs Trading

by: Hedgephone

The last two weeks have been pretty rough on investors, and many of the retail traders who buy high and sell low are likely starting to swear off equity market investing again as they mistimed the markets. Using the RSI, Stochastics, MACD, and other technical indicators can help investors to make better short term allocation decisions when scaling into and out of stock positions.

With the recent bout of selling in stocks, the market is becoming pretty oversold on a shorter term basis, and I would not be surprised to see a snapback rally in the coming days, as QE2 is still in full effect. Likewise, the sell off in silver seems to be reversing itself, although investors who bought at the top are still underwater by some 25% or so.

Here are 4 relatively cheap mega-caps to keep an eye on and buy ahead of the snapback rallies that are always around the corner at some point for equities. Keep in mind, the market appears to be in a defined downtrend right now and investors should be very conservative until we have a better view of what the economy will look like once QE2 is over. For long/short investors, consider these investments for your long book versus short positions in the IWM, QQQ, and in select overvalued tech companies.

AAPL -- Apple shares are starting to look like a bargain, trading for under 16X earnings and 11.7X forward estimates. The company has essentially doubled sales and quadrupled earnings since the financial crisis, and if the growth rate for this company can be sustained at all over the longer term, AAPL might well be worth significantly more than the current share price. Investors may want to consider writing front month, in the money call options against AAPL for some downside protection, or may consider using $330 as a stop loss level for a shorter term investment in the stock.

AAPL is a great business at a cheap valuation given their historic growth rate, but the law of large numbers is likely what has kept a lid on the appreciation of these shares. To think that this tech bellwether trades for just 11X earnings with 70% plus growth is simply mind boggling when looking at an AMZN or LNKD in comparison on a relative value basis.

GOOG -- Google shares have found some support finally after dropping quite steeply after the recent quarter earnings were released. Shares are not as cheap as AAPL, but GOOG is a smaller business with a faster growth rate and if this growth rate can be maintained, GOOG looks to be undervalued. At a 13X forward P/E ratio, shares of this search engine look like a steal when compared with YOKU, BIDU, LNKD, AMZN, and others.

GOOG was the original high P/E name that no one could figure out, but now that the internet itself is a more mature industry, I doubt that many of the newcomers will be able to match GOOG's meteoric rise going forward. Investors looking to buy GOOG on the cheap should consider selling the June $500 put options for $4.7 per contract which yields around 1% per month and gives investors a limit order at a much lower price just in case the "Sell in May and Go Away" axiom rings true for the rest of the month and into June.

SNDK -- SanDisk has been completely torn apart in recent weeks. Much like RIMM, the stock is trading on a worst case scenario basis and it's as if investors view the stock as a buggy whip maker. SNKD is on the Magic Formula list, trades for under 9X earnings and for an EV/EBITDA ratio of around 5X, and could bounce back heavily if the company can outperform the low expectations that Wall Street has given to the business.

SanDisk is similar to a Seagate (NASDAQ:STX) or a Western Digital (NYSE:WDC) in that it is a value tech stock that everyone hates passionately. STX and WDC rebounded quite nicely after the weak hands folded and the stocks were revalued higher based on earnings and cash flows and not the rumor mill and industry fears of obsolescence.

INTC -- Intel shares are still up quite nicely from their lows in the $19 range, but the stock is more than 5% off of the highs it reached a couple of weeks ago. The stock is once again looking cheap, and I feel investors can buy back into the name for a longer term purchase at this price and sell front month calls against the stock for a little bit of insurance.

Selling INTC January 2012 $22 puts is also an interesting option for investors who like the stock but would like to own it even more at a lower price. Personally, I think INTC shares have a lot of room to move higher in the coming months, but much of the rally will depend on the technology cycle and the overall market. Growth at INTC continues to be quite strong at over 20% and the company trades for just 10.46X earnings and 9.5X estimates.

Here are 4 overvalued investments that should fall if the markets continue to sink and should make for a good pairs trade against the four stocks mentioned above:

AMZN -- Amazon is expensive at 88X earnings, the company has exhibited slowing earnings growth, and the stock is overrated by the investment community. If analysts did a proper job of cash flow analysis, they would see that AMZN's operating cash flows are largely a mirage based on increasing short term liabilities. I think the stock could trade at much lower prices and that revenue growth is simply not a panacea for higher stock prices over time. Earnings and book value are what investors should focus on, as bear markets tend to hurt high P/E and high P/B stocks more than stocks that have a margin of safety from a valuation standpoint.

CRM -- CRM shares are in a bubble, much like LNKD shares. The stock is trading for an amazing P/E multiple well over 300X earnings, while the business has yet to prove itself on the profit and loss side of things. CRM is a great company and idea, but the stock is simply not worth half of its current market cap. Shorting CRM seems like a no-brainer after the company revealed that they will be losing money over the next year or two on a GAAP basis (which is what analysts should use).

Like AMZN, if analysts back out the rising accounts payable and increasing short term liabilities on CRM's cash flow statement, they will see that this business is not generating very much at all in the way of free cash flow and the company is now operating at a loss on earnings. CRM looks to be the perfect short to compliment a long position in an AAPL or GOOG at these prices/valuations.

NFLX -- Netflix is not as overvalued as AMZN or CRM, but it is certainly overvalued when compared to AAPL, INTC, GOOG, or SNDK. NFLX shares are at a 70 P/E multiple and are more of a consumer type name like AAPL then a technology name like GOOG. I can't see why investors fall in love with high P/E stocks, because when a bear market erupts, the darlings of the bull market are the first to fall off of the cliff. Look to sell calls against NFLX stock or to short the name versus a short put in GOOG or AAPL.

LULU -- Lululemon has been on a tear, but this red hot consumer name carries a ton of risk if the economy slows given the company's 57X P/E multiple. LULU looks to be a good consumer hedge versus an AAPL because if the economy slows, I believe people will stop buying trendy Yoga clothing before they stop buying iPads and iPhones. LULU shares have tripled in the past year or so and the stock looks ripe for a rather large correction at these prices.

Disclosure: I am long AAPL, SNDK.

Additional disclosure: I am short CRM, AMZN, LULU, NFLX; I may buy GOOG or INTC in the next few days.