By David Sterman
In investing, there's a time to focus on reward and a time to focus on risk. In a clearly growing economy, it always pays to find the companies best positioned to grow steadily. In better times, investors have been amply rewarded for their focus on high-growth stocks like Salesforce.com (NYSE:CRM), Chipotle Mexican Grill (NYSE:CMG), and Netflix (NASDAQ:NFLX).
But right now, investors should focus on risk. I've been focusing on the cheapest stocks in the market in the past few weeks, not only because they have considerable upside when the market rebounds, but also because their rock-bottom valuations tend to lend meaningful downside protection. You'd be taking less risk if you invested in a stock that's already well below book value or in a company that supports sustainable free cash flow.
More to the point, you should really be concerned about the "reward"-type stocks right now, because they may take a hit from two factors. First, their lofty profit forecasts may need to come down once even the most bullish analysts start to realize the slow economy will crimp business. Second, a lower target price-to-earnings (P/E) ratio on those lowered earnings will likely shrink the stock price even more.
The stocks in the table below highlight the most expensive stocks in the S&P 500 right now. I've excluded real estate stocks, which are better valued on their assets than their profits right now.
Of course, just looking at the P/E ratio doesn't tell you everything about the stock. Telecom equipment maker Tellabs (NASDAQ:TLAB), for instance, may seem expensive at nearly 100 times projected 2012 profits, but the stock has support from more than $1 billion in net cash, which is almost the entire market value of the company.
But many other names on this list appear quite vulnerable, simply because they may be sold off when investors have to choose which stocks in their portfolio are worth retaining (i.e. the cheapest) and which are worth unloading.
Let's take Netflix as an example. In May, I cautioned shares looked very expensive at 40 times projected 2012 earnings. The stock has fallen by about $50 since, so the forward multiple is a bit more reasonable at roughly 30. The stock would be even cheaper were it not for expectations of continued explosive growth in 2012. This is because analysts predict sales could rise 38% to $4.55 billion and per-share profits could soar 47% to $6.68.
Yet those analysts fail to account for a pair of factors that could cause Netflix to undershoot these forecasts by a significant margin. First, the company has recently changed its pricing plans, separating out streaming customers from DVD-by-mail customers, ostensibly to squeeze more revenue out of each customer. Trouble is, Netflix streams very few titles that customers actually want to see. So how many customers may look to downgrade rather than upgrade their service, as a few friends and I have already done?
The other concern stems from market saturation. I'm hard-pressed to find anyone in my social circle that has yet to hear about Netflix and its service. To assume Netflix will keep finding new customers at a very fast pace (while holding on to existing customers) may be a mistake. Yes, Netflix is now moving into Latin America, but the all-important U.S. market looks a lot closer to maturity than analysts presume. If the forecast of 38% sales growth in 2012 -- which is ambitious -- needs to come down as I suspect, then shares will see their multiple compressed, perhaps closer to 25 times projected 2012 profits. When combined with lower forecasts, this could cause the stock to fall another 30% from here.
I ran through my bearish concerns for CRM in June; shares are off "only" 16% since then. They actually rose higher after my bearish outlook, to then drop 30% during late summer market rout. But at nearly 70 times projected 2012 profits, the selling may not be done.
My biggest concern is analysts have yet to alter their bullish growth forecasts for 2012, seemingly oblivious to the fact that information-technology budgets are starting to get cut. Analysts were slow to cut their outlooks for tech spending in 2008, even after it had become apparent that a weakening economy put a crimp on this discretionary area of spending. It looks as if it may be happening again.
Salesforce.com gets such a big P/E multiple because it has been a phenomenal growth story. Sales grew at least 40% for seven straight years until fiscal (January) 2009, though growth then slowed to about 20% to 25% in the past two years. Growth is expected to rebound above 30% this year, but this is largely due to acquisitions.
The concern for Salesforce.com is the same one for Netflix: Past huge growth has led to a large sales base that gets harder to grow. Analysts don't usually declare a market has become saturated until a high-growth company suddenly hits a wall. And I have yet to find the analyst that looks into how much of a potential market is left for grabs. Salesforce.com will have to fight hard with rivals to achieve any remaining organic growth. As I wrote in June, "Companies like Oracle (NASDAQ:ORCL), SAP and Microsoft (NASDAQ:MSFT) are taking the customer relationship software niche more seriously, so these types of firms have a tendency to compete very aggressively on price."
This is why a multiple of 70 times projected 2012 earnings simply seems unjustified in these sobering times. Any signs of growth challenges could wreak havoc on shares.
These are high-beta stocks, so any sharp market rebound could give a new lift to shares. This is why it's a challenge to short these stocks. But if you feel tempted, then be sure to set protective stops. Your portfolio should have a clear tilt toward value stocks right now. Focusing on high-growth names is a strategy best pursued in times of rising markets and a growing economy. This bullish backdrop is likely off the table for at least the rest of 2011.
If you decide to pursue growth-oriented names, be sure they look inexpensive by traditional value-oriented measures such as price-to-book (P/B), price-to-earnings or price-to-cash-flow (P/CF). And by all means, if you hold any of the stocks I mention above, then seriously reconsider.
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.