Severe Valuation Alert (September 2016)
2 Dozen “Quality” Stocks That Could Wreak Havoc in Your Portfolio
One good thing about that comes from trying to find value in an expensive market on a regular and ongoing basis is that eventually it dawns on you that among other things, there are an awful lot of stocks which offer very poor value to investors in the sense of any potential increase/decrease to their Fair Market Value (the dotted FMV line on our charts), and yet which the stock market persists in pricing at extremely high valuations (in the SVA price/book sense). When we find a stock that trades at 8 times book value or higher, and whose fair market value is only half of the current price, we have to expect that sooner or later some – or all – of that excess pricing will be taken away. Certainly, based on our experience with our FMV measure, it has had a powerful tendency to attract prices so that when we find that the downside risk of any given stock is 50-70% or more, we can say with confidence that the resulting hole that will be left in ones’ portfolio will be substantial.
When we ran the data for the S&P 500, we discovered, for instance, that 241 stocks in the S&P Index are currently trading with zero to negative Fair Market Value. Now, this is not the bottom of the stock market in a nasty recession that we are referring to, where earnings may have disappeared for the time being and which are likely to bounce back when the economy turns stronger, but eight years into a bull market expansion during which time investor confidence in a number of stocks has vastly outrun the ability of the underlying companies to generate supporting value. Worse, the overall earnings for the S&P 500 have been weakening for 5 quarters running. Of course, the analysts are claiming that 2017 will be a strong rebound year. It will have to be – and in some cases, several more – in order to justify paying some of the prices/valuations that we are seeing. But there is scant evidence that anything like that is remotely possible, save in the imaginations of those forecasting what may well turn out to be impossible earnings.
We have been here before. Only the names of the stocks have been changed to protect the innocently naïve. In 2000, it was high technology with their “for sure” big earnings gains needed to justify their outrageous market price/book valuations. Today, it is Tesla and Netflix among others where big sales and earnings growth are coming – for sure – to justify their massive valuations. Maybe yes, and maybe no – but when the stock market begins to pay for results too many years in advance of their appearance, then it is time for a little prudence to prevail.
When we ran the data for the TSX, of the 230 stocks that we have data for, 130 have zero to negative FMV Potential, with 96 showing actual downside FMV risk potential. We have to underline the reality that nothing is for certain, and just because there is negative FMV potential, it does not mean that a given stock will crater, or even go down. However, in our experience with this measure, when markets do fall, the stocks with very poor FMV potential often do very badly by outperforming other stocks on the downside. The issue is that the same psychology that drove the stocks up way in excess of any semblance of reasonable value, gets turned around against those same winners. We have only to consider the recent experience of Valeant Pharmaceuticals (VRX). When things were going well, management were geniuses, and industry consolidation was the miracle answer to creating value. In the crash, the leverage generated and the questionable goodwill that resulted from high-priced acquisitions saw investors panic when they realized that perhaps there was no, or very little, value at all. Back in 2000, Nortel Networks management created what investors thought was a powerhouse of a company – until investors suddenly realized that they were paying 100 times earnings for a company that was only growing at 15-20% per annum at best (and with a balance sheet equity had virtually all been replaced by goodwill). For the companies that we highlight below, we suggest that you take their bullish “story” and twist it back around and see what you think then. Think about Netflix (NFLX) one of our choices below. Netflix is going to entertain the entire world and is expanding everywhere. Now consider that every telco they are up against is trying to generate content for their own service. Positive earnings are hard to come by and competition is brutal. What is this stock really worth? Time will tell, but at 15 times book value, and an FMV potential of -85%, we for one do not intend to find out by personal experience.
In alphabetical order by company name but not by stock symbol, here are the stocks of two dozen major North American companies whose businesses look unassailable and therefore whose stock prices equally ‘safe and secure’ but who history tells us all too clearly, are vulnerable to massive price declines even if not a lot happens to their future earnings.
3M Company (MMM- $179.60)
3M has climbed back to its usual extreme valuation high, its SVA Bubble Price (7.4 times adjusted book). Earnings growth has slowed to a crawl over the past 2 years, and although share buybacks have reduced that Bubble Price by about 22%, they appear to have done nothing for the average earnings per share numbers. The Fair market Value (“FMV”) measure is currently 21.3% lower than the market price. Historically, the market has moved the stock above its FMV measure, but also historically, the FMV has always pulled the price back down to and below that critical measure. Without visible growth and an extended valuation, we can see no investment potential for the stock at this time.
Current MV Ratio (Price/book) 7.9x Current FMV (+/-) -22%
Amazon.com Inc. (AMZN – $760)
Amazon may be the most problematic of our 24 over-valued stocks because it is not only fast-growing, but also its Fair Market Value based on current earnings forecasts have been rising at a very high rate over the past 2 years – which is due to the massive investment in e-commerce and which is beginning to pay off in terms of earnings and balance sheet growth. Having noted that, the stock is trading at 36.4 times its book value, the PE Ratio stands at 87, and the Fair Market Value of the stock stands at -79%. In the past, the stock has exhibited huge volatility in weak markets and therefore we would have to conclude that the supporting values – however rapidly they are ‘catching up’ with the current price – still represent massive investment risks to investors.
Current MV Ratio (Price/book) 36.4x Current FMV (+/-) -79%
Altria Group Inc. (MO) – $66.35
This venerable tobacco and now wine company has enjoyed a terrific gain of over 400% from the lows of 2008-9 to the current day. In the process, the share price has moved well above our Fair Market Value (“FMV”) calculation ($42.25) to a level which is 40% above that measure at the present time. The reason that we are concerned here is that in a bear market, that FMV will not only exert strong downwards pull on the price, but also, if the company’s own valuation history has any influence, the market price of the shares will fall well below that measure before it finds a low. It is probably safe to project a good discount to the FMV of about the same degree as the current price exceeds it today. While the company’s earnings have enjoyed a steady increase over that period, the market valuation (in price to book terms) has grown much more rapidly – and therefore can fall just as easily.
Current MV Ratio (Price/book) 24.3x Current FMV (+/-) -36%
The Coca-Cola Company (KO) – $43.75
In recent years, the earnings growth of KO has slowed not only to a crawl but have actually fallen on a per share basis since 2013. The company has been buying back stock to boot, so the decline is even more startling. The Fair Market Value of KO is well below the current market price such that it is impossible for us to identify any reason for holding this stock, save for a modestly decent 3.2% dividend yield. In the 2008 bear market, KO fell from a premium to its FMV to a good discount and we have less reason to suppose that this time around should be any different because the fundamentals – including a negative balance sheet trend – all seem to be aligned against the investor. The stock reached the same maximum valuation, the Bubble Price or about 8 times book value, that it did at the peak in early 2008, and is now trending lower, as far as we are able to ascertain.
Current MV Ratio (Price/book) 6.4x Current FMV (+/-) -23%
Colgate-Palmolive Co (CL) – $74.50
Sometimes, you have to stare in stunned admiration at what the market will pay of a given company, and CL is one such example. Although the balance sheet has been declining for years now, and if stock buybacks were supposed to enhance the earnings outlook in this case, they have not, as the earnings per share have been flat or in decline over the same period, the price/book of CL has reached a 120 times (and a paltry 2% yield). The current FMV potential for the stock is now 58% lower than the market price and so we can only imagine what might happen if market conditions became hostile to growth stocks in general and massively over-priced ones in particular. We cannot say that there is any evidence that the shares are about to do anything except head higher but we do not want to be there if the music ever stops.
Current MV Ratio (Price/book) 129.3x Current FMV (+/-) -58%
Constellation Software (CSU) – $545 (TSX)
Constellation Software Inc. is probably one of the largest companies ($11+ billion market cap) that you have never heard of. It is a Canada-based company, engaged in acquiring, managing and building vertical market software (VMS) businesses. The Company operates through two segments: public sector and private sector. It is also engaged in the provision of professional services and support. The shares have enjoyed an almost straight up run since 2006 from roughly $22 to $580 with only a modest blip in that trend in 2008-9. For a lot of that time, however, the stock price was lower than its Fair Market Value, which we cannot no longer say today, as the share price now exceeds the FMV by some 45%. Since the FMV does exert a powerful pull on price, any significant market weakness is highly likely to draw CSU towards (and usually below) that value, particularly because the price to book now stands at 18.8, a heady valuation by almost any measure.
Current MV Ratio (Price/book) 19.2x Current FMV (+/-) -46%
Costco (COST) – $168
Costco has attained a valuation of 5.5 times book last experienced in early 2000, and is trading well above its FMV measure of $110. What is peculiar about this is that the growth in book value has slowed to a crawl (although the earnings per share have managed to maintain a decent rate of annual gain). The shares are now 35% above their FMV measure. The decline from the last valuation peak was severe and we would not expect anything different this time around. The usual low following every bear market has been the Growth Price (‘G’ Price) of the stock which currently stands at $61. Pardon us if we stand aside from this one.
Current MV Ratio (Price/book) 5.5x Current FMV (+/-) -34%
Dollarama Inc. (DOL – $99.50)
DOL is untested by the fickle finger of market fate (a bear market) but is already indulging in some stupid capital market moves that will guarantee that downside price pressures – when they come – will be severe, namely the buying back of stock which is diminishing the book value support as well as diminishing the capital available for expansion in the future, and hence its intrinsic growth outlook in the longer term. The company is currently trading at 24.3 times book value, and its current Fair Market Value is 47% below the current price. It may be the only dollar store game in the Canadian market which appears to have given it a cachet that its results and current value to not support. In weak markets, expensive stocks tend to move back to, and then a discount to, their FMV values. The stock could fall to $30, and still trade as what we refer to as a bubble stock (any stock with a valuation above 8 times book). Caution in this Canadian growth favourite.
Current MV Ratio (Price/book) 24.3x Current FMV (+/-) -47%
Fiserv Inc. (FISV – $102.70)
Fiserv, Inc. (Fiserv) is a major global provider of financial services technology. The shares are currently trading at their highest valuation ever, having recently risen to their Bubble Price (7.4 times book) before setting back very modestly this far. The stock is 21% above its Fair Market Value, having enjoyed a 1000% price gain since 2008. Of all of our choices, changes in payments methodology is enjoying great optimism so this stock may hold up better than most. But is own history tells us that valuation has become extended and the potential markets risks are rising significantly.
Current MV Ratio (Price/book) 7.4x Current FMV (+/-) -21%
Home Depot Inc. (HD – $135)
HD is trading at the highest price/book ratio that it is has [ever] enjoyed, at least for the past 25 years. It is also trading at 30% above its Fair Market Value. While the company has “been here before”, it has also had a nasty tendency to fall back to and then below its FMV measure. Worse – from our point of view – the company has been buying back its own stock at very high price/book levels which diminishes its ability to expand in the future while providing very little benefit to ongoing shareholders in the way of increased earnings per share. We admit that we do not know what is going to happen to such companies in the years ahead, but we do suspect that when companies do things that do make economic sense, eventually their shareholders will pay for those mistakes. Just to remain as a Bubble-valued stock (7.4 times book or greater), the shares could currently fall to $57, which offers scant comfort to investors.
Current MV Ratio (Price/book) 17.7x Current FMV (+/-) -29%
Illumina INC. (ILMN – $169.50)
Illumina, Inc. is engaged in production development of sequencing-and array-based solutions for genetic analysis. The stock has already suffered a fair setback from its peak valuation to its current price/book ratio of 10.8 times, but in the past, the stock has set back to its Fair Market Value measure, which currently stands at -59.5%. The investment risks into what may be late in the market cycle are therefore considerable. Earnings growth has slowed to a crawl over the past year and, should that trend continue, is likely to cause a further decline in the market price of the shares.
Current MV Ratio (Price/book) 10.8x Current FMV (+/-) -59%
L Brands Inc. (LB – $77.25)
L Brands, Inc. is a specialty retailer of women’s intimate and other apparel, beauty and personal care products and accessories including Victoria’s Secret. The stock has an almost mystical valuation, trading as it does at almost 80 times its book value, although ‘only’ 20 times earnings. If earnings were growing more rapidly, or the business segment more esoteric, we might understand a little better. Furthermore, the book value has not been growing very rapidly either, although that is due to stock buybacks which further inhibits future growth potential. Anything this expensive triggers an ‘Alert’ in our valuation methodology, and this would be a stock that we would cheerfully avoid.
Current MV Ratio (Price/book) 79.7x Current FMV (+/-) -46%
McDonald’s Corp (MCD – $114.85)
In the 25 years of valuation history that we have for MCD, the shares have exceeded their Fair Market Value measure only once before. What followed was not the sort of experience that any investor on the long side of the market would choose to suffer. So MCD is up there again, and they are cheerfully buying back stock at extreme prices and collapsing the book value support under the stock while their earnings per share growth and hence their Fair Market Value have totally stalled out for the past 5 years. The company could fall to $48 and still remain with what we term a Bubble Valuation of 7.4 times book value or greater – which would be merited (in a sense) by its very high ROE, but that might offer slim solace to the investor.
Current MV Ratio (Price/book) 17.6x Current FMV (+/-) -28%
Mead Johnson Nutrition Co. (MJN – $83.25)
MJN stock has gone virtually nowhere in the past 5 years, although it has done so with considerable volatility. Even the earnings per share have been quite flat over the same period. At the same time, the price/book per share has been about 100 times, which is to say that there has been no real book value under the share price whatsoever, allowing for a very Fair Market Value (although the share price still exceeds its FMV by some 53%). The company has managed to achieve this feat by dint of having an extremely high ROE on what equity that it does have. To our way of thinking, the shares do not represent investment value in any meaningful way or in any traditional way of analysis. As the shares have only been public since 2009, there are no historical metrics or guidelines to judge the eventual market outcome for the share price in any potential weak market, so any ‘forecast’ of the future price action is purely notional. On the other hand, What parallels that we do have with similar kinds of valuations would not encourage us to be optimistic about the price outcome for MJN over any longer term time horizon.
Current MV Ratio (Price/book) 100x Current FMV (+/-) -53%
Netflix Inc. (NFLX – $95.20)
Netflix is going to entertain the entire world and is expanding everywhere. But consider that every telco they are up against are also trying to generate content for their own service. Positive earnings have been hard to come by and competition is brutal. What is this stock really worth? Time will tell, but at 15 times book value, a PE Ratio of 143 next year’s earnings, and an FMV potential of -85%, we for one do not intend to find out by personal experience.
Current MV Ratio (Price/book) 14.7x Current FMV (+/-) -85%
Nike Inc. (NKE – $60.25)
NKE has only traded up this high – at its Bubble Price or 7.4 times book value – only twice before in its past 25 years of valuation history, and both times came to an unfortunate conclusion for investors. It has also only traded above its Fair Market Value during the same two extreme events. The PE Ratio is also very high relative to most other stocks and the yield is tiny. We therefore have to conclude that the risks in this stock now considerably outweigh any potential returns that may be available and therefore the shares should be held by anyone else except our readers.
Current MV Ratio (Price/book) 7.1x Current FMV (+/-) -30%
NVIDIA Corporation (NVDA – $62)
NVIDIA Corporation (NVIDIA) is engaged in visual computing, enabling individuals to interact with digital ideas, data and entertainment. With a $33 billion market cap, this is also one pf the largest companies that not many investors have really heard about. It has enjoyed a powerful run in the past year, doubling in price from 3.5 times book to 7.4, and in the process, outstripping its Fair market Value by a solid 50%. Based on its past history of trading, the stock could easily lose 50% of its price in a market setback as a sort of ‘routine matter’ and so we would be extremely careful at current valuation levels – while also being aware that such a tumble could open up a superb buying opportunity, again based its past history.
Current MV Ratio (Price/book) 7.2x Current FMV (+/-) -52%
Paychex Inc. (PAYX – $60.70)
The growth rate of PAYX – as measured by its balance sheet equity per share – of this company has markedly slowed in the past 8 years but the share valuation has happily plowed ahead back to an above the Bubble Valuation that it enjoyed when it was growing much more rapidly. The company has outrun its Fair Market Value by some 39% at this juncture, although it does have a nice 3% yield (which absorbs nearly all of the earnings that the business produces). Growth in earnings only modestly exceeds the equity value per share growth. A once-impressive growth story is coming to earth – as one would expect with the size that the company has achieved.
Current MV Ratio (Price/book) 10x Current FMV (+/-) -39%
Starbucks Corp ((SBUX – $57.10)
Been there before, done that before, got crushed before. SBUX is back up at its usual extreme valuation and has managed to run well ahead of its Fair Market Value to boot. The growth rate of the equity per share has slowed even allowing for the share buybacks and the yield is nothing to write home about.
Current MV Ratio (Price/book) 13.4x Current FMV (+/-) -32%
Tesla Motors Inc. (TSLA – $222.60)
This should be an interesting stock to watch in any market weakness, or worse, a meltdown. The company is running on hot air and hope, having managed to miss virtually every business target set for it. Worse, the balance sheet is very weak as we measure it so there is nothing in the tank if the market price fails to hold up. Lots of promise but poor delivery. This is a raging bull market stock but not one for the faint of heart if ever markets weaken.
Current MV Ratio (Price/book) 15.2x Current FMV (+/-) -88%
Under Armour Inc. (UA – $43.15)
Under Armour, Inc. is engaged in the development, marketing and distribution of branded performance apparel, footwear and accessories for men, women and youth. The company started out 2016 with an impressive 22% jump in price as it beat estimates by $.02 on a 95% surge in show sales – and that was about it for the year to date! What this proves, we are not sure, but we do wonder whether all of those nice price jumps following under-estimates for earnings that come in 2 or 3% above those estimates wind up the same way – buyer’s remorse. The shares are significantly over-valued based on their FMV measure and we would be concerned that the shares will not hold their price in weak markets.
Current MV Ratio (Price/book) 9.9x Current FMV (+/-) -68%
Verisign Inc. (VRSN – $74.45)
If you have ever wondered who manages all of those web domain names, and hopefully stops people from copying yours, here’s your answer. VeriSign, Inc. is a global provider of domain name registry services and Internet security, enabling Internet navigation for domain names and providing protection for Websites and enterprises around the world (Registry Services). Make no mistake, VRSN has not only had a great run in the stock market, but with a 350% ROE may be able to hold its’ valuation as well. The problem is now what? The stock has a massive valuation, is trading with an FMV measure of -46%, no dividend at all despite its huge profitability. It makes one wonder what they do with all the money that they make. The Stability Ratio is not all that strong, so clearly they are not sitting on bags of cash. Hmmm. Perhaps this will continue to do well regardless of the intrinsic value, but we would not touch anything that looked like this under any circumstances.
Current MV Ratio (Price/book) 72x Current FMV (+/-) -46%
Vertex Pharmaceuticals Inc. (VRTX – $97.71
Vertex Pharmaceuticals Incorporated (Vertex) is a global biotechnology company. The Company is engaged in the business of discovering, developing, manufacturing and commercializing small molecule drugs. The shares have had a wild ride over the past 15 years, and to judge by what the company is doing and its current metrics, we can probably expect more of the same ahead. Right now, the shares have been on a roll, are very expensive on a price/book basis, a PE basis, and a Fair Market Value basis. On top of all that, if anyone by the name of ‘Clinton’ gets into the White House in November, we suspect that the pharma companies are going to have a much rougher ride in the future than they have had since the last Clinton left that office. Talk about hopes, dreams and waking up screaming. VRTX has had it all with more to come, as far as we can see.
Current MV Ratio (Price/book) 21.2x Current FMV (+/-) -62%
Yum! Brands Inc. (YUM – $89.75)
Yum! has reached what may or may not prove to be a double top at the $90 level, but from a valuation point of view, deserves to be a maximum. As we observed last year about this time, “No matter how poor your basic stock values, buy back some stock and the market will drive your shares higher – but not forever. Sooner of later, you have to produce sales and earnings. Or, as YUM found out, your stock price drops. Poor value, risky. We would avoid the stock.” Well, as it turned out, the shares did suffer a hefty decline, but then recovered right back to their previous price high, but well above their previous valuation high in price/book terms. In the meantime, earnings forecasts have been steadily slipping, and the over-valuation as measured by our FMV measure
Current MV Ratio (Price/book) 51.2x Current FMV (+/-) -47%