John Dorfman: Beware of stocks that sell for 100 times earnings

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Just as there are no sure winners in the stock market, there are no sure losers. But I can tell you something close.

If you want an excellent chance of losing your money, invest in a stock selling 100 times or more.

Each year, from 2000 to 2006, I compiled a warning list of these stocks. During these seven years, 39 actions were presented. Their average 12-month return was a loss of 31%. Over the same periods, the Standard & Poor’s 500 index gained an average of 4.6%.

Of the 39 stocks, 26 fell over the next 12 months and 13 rose. Six out of seven times the warning list has underperformed the S&P 500.

Improbable mathematics

Before presenting my eighth warning list, let me explain why, in my opinion, it is almost impossible for a stock to be worth 100 times its turnover.

Suppose a company manufactures karaoke equipment. Imagine there’s a huge fad involving karaoke singing and assume the company’s gear is endorsed by Taylor Swift and Justin Timberlake

In this festive atmosphere, the title sells for 100 times its turnover. Can this be a good investment?

Suppose the company grows revenue by 40% per year for five years and achieves a pre-tax margin of 45%, better than Microsoft Corp.

After five years, assuming the stock price remains unchanged, stocks will earn 41 times earnings, a multiple well above average.

Note how optimistic the assumptions are. But what are the chances of everything going well? Maybe in five years, bowling will supplant karaoke, Justin Timberlake will be overtaken, and Taylor Swift will have settled down to raise kids.

The example is ironic, but the principle is generally true. When a title is rated at perfection, perfection rarely occurs.

Passion for biotechnology

Many of the stocks I’ve highlighted over the years that sold for more than 100 times revenue were biotech companies. Some have scored gains. Vicuron Pharmaceuticals Inc., for example, grew 64% in 2005-2006 when it was acquired by Pfizer Inc. (PFE).

But several have been disasters. For example, Telik Inc., on the 2005 list, fell 70% in one year. Transkaryotic Therapies Inc, on the 2002 list, fell 88%. Human Genome Sciences Inc., twice on the list, fell 54% in 2001-02 and 71% in 2002-03.

Proponents of biotech stocks have valid points. Big pharma acquires biotech companies to gain access to their research. And one day, a biotech company might discover a cure for cancer. My problem with biotech stocks is that many of them are quoted as if they would be the ones to make this discovery, and soon.

I will put two biotech companies on the warning list this year: Inhibitex Inc. (INHX) at 888 times sales and Ziopharm Oncology Inc. (ZIOP) at 752 times sales. Inhibitex focuses on the prevention and treatment of bacterial and fungal infections in hospitals. Ziopharm is trying to develop and acquire cancer drugs.

Star Scientific Inc. (CIGX) of Glenn Allen, Va., sells for 457 times its revenue. It’s a story stock, but the story changes from time to time. Sometimes it’s about the odds of striking gold in a lawsuit against RJ Reynolds Tobacco. Sometimes it is a lozenge to help people quit smoking. And lastly, it’s a nutritional product that the company claims could fight Alzheimer’s disease.

Pendrell Corp. (PCO) is an intellectual property company based in Kirkland, Washington. The company holds a slew of patents, including about 260 that it recently picked up with its $90 million acquisition of private company ContentGuard. Pendrell shares earn 528 times earnings.

Houston American Energy Corp. is a junior oil and gas company based in Houston. So far this year (through September), his earnings have been under $1 million. And yet, its stock market value is $390 million. Its price/income ratio is 126.

I recommend avoiding these five actions. If you happen to be a short seller, betting on the decline of selected stocks, these might be candidates for investigation. My company and I have no positions in these stocks, long or short.

For those wondering, Facebook’s upcoming IPO will not involve a price/income multiple of 100. Based on market rumors, the multiple will likely be around 25. — still vastly overvalued in my opinion.

John Dorfman is president of Dorfman Value Investments LLC in Newton Upper Falls, Mass., and a syndicated columnist. His company or his clients may own or trade in the securities discussed in this column. He can be reached by email.

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