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Death
List = High Risk
With the Dow hitting new highs almost daily, the market has been fun
lately. Many stocks have already scored big gains this year, and it’s
tempting to try to get in on the action.
Unfortunately, it’s easy to get caught up in the excitement and pay too
much for stocks that have already seen their best days.
To avoid that trap, I’ve adopted a simple test for identifying stocks
that have gone up too far, too fast. I call them “death list”
stocks, because, when the market cools, they will likely take the
biggest hits.
Barron's Idea
Although I coined the term, I didn’t come up with the “death
list” criteria on my own. I swiped the idea from Barron’s, the weekly
stock market magazine. In the mid-1990s, Barron’s ran occasional
articles spotlighting stocks that it thought were overheated and due for
a fall.
I saved the articles and tracked the performance of Barron’s overheated
stocks. I found that Barron’s was on to something. Although not all
overheated stocks dropped, as a group, the list usually underperformed
the market over the next year or so. Since Barron’s published the
criteria that it used to identify its overheated stocks, I was able to
create my own lists, which, as I already mentioned, I dubbed the “death
list.”
My death list works reasonably well for identifying risky bets. The main
exception is that during hot markets, such as the 1999 to early 2000
timeframe when the bubble was approaching the bursting point, death list
stocks tend to outperform the overall market, instead of
underperforming.
Easy Tests
To qualify for the death list, a stock must pass four simple
tests using information readily available on many financial sites.
I’ll use Smart Money (www.smartmoney.com)
to describe the process. From Smart Money’s homepage, get a price quote,
and then select the “Key
Stats” report. Here are the four tests.
#1) Share price doubled over the past year
Any stock that moves up too quickly is risky. Barron’s
defined “too risky” as
meaning doubling in 12-months.
Although that definition was rather arbitrary,
I haven’t come up with anything better. Look for the 52-week share price
growth in the “Stock Performance & Dividends” section of Smart Money’s
Key Stats report. To qualify for the death list, the 52-week performance
must exceed 100%. When I checked last week, only 145 of the 5,700 U.S.
stocks trading above $1 per share meet that criterion (I obtained that
and similar statistics quoted in this column using Reuters Knowledge, a
service targeted mainly to industry professionals).
#2) Price/book ratio of 5 or higher
The price/book ratio is the recent share price divided by shareholders
equity (book value). Usually, ratios below two identify out-of-favor
value priced stocks, while higher ratios designate growth-priced stocks,
which most investors prefer. As of last week, around 840 stocks were
trading at price/book ratios of five or above. Find the price/book, as
well as the other required valuation ratios in the Valuation section of
Smart Money’s Key Stats report.
#3) Forward price/earnings ratio at least 45
This is the only instance where I changed Barron’s formula. The
price/earnings ratio is the recent price divided by 12-months per-share
earnings. Barron’s used the trailing 12-months (last four quarters)
earnings to calculate P/E. But the trailing earnings are often reduced
by charges related to acquisitions or other one-time events. Those
non-recurring charges artificially reduce earnings, thus, distorting the
P/E ratio.
The forward P/E uses the current year’s analyst’s consensus forecast
earnings in place of the trailing 12-months’ figure. The analysts’
forecasts do not subtract non-recurring charges, if any, so you have a
more realistic price/earnings number.
Barron’s set the minimum P/E at 50 to qualify as overheated. However, in
most cases, because earnings are expected to grow, the P/E based on this
year’s forecast earnings will be lower than the P/E based on trailing
earnings. So I compensated by reducing the minimum forward P/E to 45 to
qualify for the death list. Currently, 335 U.S. stocks meet that
requirement.
#4) Price/sales ratio of 5 or higher
The price/sales ratio is similar to P/E except the recent price is
divided by the trailing 12-months per share sales instead of earnings.
Since sales usually don’t vary as much as earnings from quarter to
quarter, the price/sales ratio is a less volatile valuation measure than
price/earnings. P/S ratios below 2 usually designate value stocks, while
higher ratios identify growth stocks. Around 1180 stocks currently
qualify for the death list based on the price/sales ratio.
To qualify for the death list, a stock must pass all four of the above
tests.
Qualifying for the death list doesn’t mean that a stock is necessarily
headed down, especially in a market as strong as we’ve recently
experienced. However, it does warn that it’s a high-risk stock likely to
underperform when the market weakens.
published 5/13/07 |
