By David Sterman
The stock market plunge in the last two months of the summer was, in hindsight, a clear overreaction. But the subsequent sharp rally may also be a false signal. Simply put, the economy remains unhealthy, Washington threatens to scare investors with an ongoing inability to agree on anything, and Italy -- a country that is 10 times larger than Greece -- looks like the latest emerging European headache.
Regardless, the playbook hasn't changed: Buy inexpensive stocks while selling (or even shorting) overvalued stocks. In a fresh market rout, the inexpensive stocks are likely to hold up better. Those overvalued stocks? Well, as we saw with former high-flier Netflix (NASDAQ:NFLX), investors can punish a high P/E stock that stumbles.
Surprisingly, there are still many pricey stocks in the market, despite all the turmoil of 2011. In fact, there are 19 stocks in the S&P 500 that trade for at least 25 times projected fiscal year (which in most cases is 2012) profits. (I'm not counting REITs and energy sector plays, as they are often more about the assets and cash flow than net income.)
To be sure, some of these richly valued names can stay that way for some time. Anyone looking to short Amazon.com (NASDAQ:AMZN) simply because management dampens near-term profits by investing in long-term growth has always lost that bet. (Although a triple-digit forward multiple hardly inspires notions of buying, either.)
Yet for some stocks, it may only be a matter of time before a high price-to-earnings (P/E) ratio comes back to bite. For example, I suggested shorting software vendor Salesforce.com (NYSE:CRM) back in June, and though the stock has since shed about $10 to drop to a recent $131, it still looks very expensive. In my view, analysts overestimate the company's ability to keep growing and underestimate budding competition.
For example, Oracle's (NASDAQ:ORCL) recently proposed $1.5 billion acquisition of RightNow Technologies (NASDAQ:RNOW) should create formidable competition for Salesforce.com in the customer relationship management business.
Beyond looming competition, it's an unusual accounting practice that may trip up this stock. Salesforce.com expends a significant amount of money trying to snag new customers. Because those new customers sign up for monthly subscribed access to its software, Salesforce's accountants believe sales commissions deserve to be capitalized as long-lived assets, rather than the more typical expense accounting that most other firms employ when it comes to sales commissions. By one estimate, this capitalization rather than expensing of sales expenses has overinflated Salesforce's earnings by 40%. We're talking about a company that already trades for more than 70 times fiscal (January) 2013 earnings, so the real multiple may be closer to 100.
Rising competition and questionable accounting will again come under scrutiny when Salesforce reports fiscal (October) third-quarter results on Nov. 17. For such a richly priced stock, any stumble in this high-growth story could be painful.
Whole Foods Markets (NASDAQ:WFM): This high-end grocer has always been richly valued for its ability to deliver very strong profit growth on the heels of ever-expanding profit margins. Yet those margin gains may soon be harder to come by, as Whole Foods feels the pressure of rising food inflation and a customer base that has already had to put up with a series of price hikes this year.
The inability to boost margins further has already begun to bite. After rising 69% in fiscal (September) 2010 and 35% in fiscal 2011, earnings per share are expected to rise around 15% in fiscal 2012 and fiscal 2013. This makes the high forward multiple begin to stand out.
Of course, even if margin gains are a thing of the past, new store openings can keep the top and bottom lines rolling. Whole Foods has roughly 320 stores, and management thinks there is potential for 1,000 stores blanketing the nation. Really? It seems that Whole Foods has done an outstanding job in all of the relatively affluent neighborhoods in the United States that have the demographics to support relatively expensive groceries. The next 680 stores aren't likely to be nearly as supportive, especially in these stressed times for consumers.
Those potential locales are already served by more traditional grocery chains, all of which have taken note of the company's winning formula. "Conventional grocery chains such as Safeway (NYSE:SWY) have remodeled stores at a rapid clip and attempted to narrow the gap with premium grocers like Whole Foods in terms of shopping experience, product quality and selection of takeout foods," note analysts at Morningstar.
And those firms make do with much smaller profit margins. Trader Joe's, which serves the same audience, has been opening 40 new stores a year in many of the same neighborhoods that Whole Foods hopes to target.
Make no mistake, Whole Foods is an impressive growth story. But the still-high forward multiple is ignoring the reality of a maturing business model that will see slower earnings growth in years to come.
Risks to Consider: A lot of these high-multiple stocks already have significant short interest. Any further upward move in the broader market could cause short sellers to cover their positions, sending these shares even higher.
Many of these stocks aren't so much clear short candidates as they are candidates for profit-taking. History has shown that high-multiple stocks take the deepest hits in a fast-falling stock market. With all of the headwinds still in place, such a prospect can't be discounted. So even if you aren't looking for a stock to short, you should consider booking profits if you own any of these stocks.
Disclosure: Neither I nor StreetAuthority, LLC hold positions in any securities mentioned in this article.