By David Sterman
With the stock market swinging triple digits from one day to the next, it's become apparent to me that recent gains are being slowly harvested. Rather than undergoing an outright selloff, investors are broadening their list of targets to book gains and raise cash. Some stocks have been immune to this process, but their too-rich valuations may soon make them the target for profit-taking or perhaps even short-selling.
It's easy to find these short-selling candidates. They're the ones with high price-to-earnings (P/E) ratios and tepid earnings growth rates. In effect, they're "high PEG" stocks (P/E divided by the earnings growth rate). For example, a stock trading for 20 times next year's earnings and is expected to boost earnings by 10% would have a PEG ratio of 2. That's quite high. (Using this measure, stocks with a PEG ratio below 1 are usually the most appealing.)
With this in mind, I screened high PEG stocks in the S&P 500 (SPY). Here's what I've found...
Forest Labs (NYSE: FRX)
Although not always associated with the "Big Pharma" plays like Merck (NYSE: MRK) and Pfizer (NYSE: PFE), Forest Labs shares one thing in common with them: an imminent loss of a key drug that will wreck the company's bottom-line, since its sales make up for almost half of the company's total revenue. Lexapro, a popular anti-depressant, will lose patent protection on March 14, 2012. In fiscal 2011, Forest Labs reported about $1 billion in net profits, or $3.59 a share. However, as a result of Lexapro's patent expiration, analysts expect per-share profits to fall more than 50% from a projected $3.70 in fiscal 2012 to $1.20 in fiscal 2013. To make up for this big hole, the company is scrambling to prep other drugs for approval by the Food and Drug Administration.
Replacing one large drug with a series of smaller unproven drugs is a risky game. There's no assurance each of the smaller drugs will get approval, and there's no assurance doctors will actively prescribe the new drugs. Because of this scenario, analysts at Needham are taking a cautious stance. They expect Forest's sales to peak at $4.3 billion in the current fiscal year that ends next March (thanks to Lexapro). In addition, despite expectations of relative success for a range of newly-approved drugs, they still see sales dropping to $3.3 billion by 2016.
Shares may look reasonably priced on a trailing earnings basis, but they look quite expensive in the context of future profits. The stock trades for more 30 times projected 2013 profits and more than 40 times Needham's projected 2016 profits if you look further out. If Forest executes perfectly on plan, then shares will likely be fully-valued. But if the company's drug development efforts prove challenging, then shares may eventually fall by half.
Intuitive Surgical (ISRG)
Since then, shares of NuVasive are up 32%, while shares of Intuitive is up 27%. This paired trade would have only made a modest profit. But for patient investors, the pullback for Intuitive I have been anticipating may still arrive.
Intuitive Surgical pioneered the market for robotic surgery in the late 1990s and went on to post stunning growth in the following decade. Sales have risen at least 27% since 2002 (with the exception of 20% growth in 2009). But thanks to rising competition from NuVasive and others, a tougher health care reimbursement environment and the effects of the "laws of bigness" (sales could hit $2 billion by next year), it's getting harder to move the needle at a fast clip.
This is not to say Intuitive Surgical is headed for a trouble, but its best days of explosive growth have passed. Sales are likely to grow 18% this year, 16% in 2012 and perhaps less than 15% in 2013, according to analysts' preliminary forecasts.
Merrill Lynch launched coverage of Intuitive in May 2011, with favorable impressions, but noted concerns that shares carry a very high valuation relative to earnings and growth. In coming up with their "neutral" rating, analysts noted the stock would likely be a better bet at a lower valuation.
Analysts at Goldman Sachs, on the other hand, go a step further, slapping a "sell" tag on the stock with a $270 price target. They note Intuitive is becoming more dependent on repeat systems sales and are concerned that most major hospital accounts have already been penetrated. The key question on growth is whether the company can open up a major new procedure category. Since they are a bit dubious of that happening, analysts continue to see the risk/reward as "skewed to the downside."
In a market that may keep retrenching in coming quarters, these high-multiple stocks are especially vulnerable and could fall further father than most. If you own any of the stocks in the table above, this may be the right time for profit-taking. They may also prove to be a good short-selling opportunity.