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One of the biggest mistakes many investors -- including me -- make is arriving too late at the party.
You know the drill. It seems that everyone you know is talking about how much money they've made on a stock. The temptation is overwhelming. Even though you should know better, you eventually give in and jump on the stock -- just before it falls off a cliff.
To avoid repeating that mistake, I've adopted a simple method for identifying what I've dubbed "doomed stocks," superheated stocks more likely to head down than up.
To qualify as doomed, a stock must have doubled in price over the past year and be overvalued by three measures: price to book, price to sales and price to earnings. I'll fill in the details in a minute and give you a screen for listing doomed stocks. But first, some background.
A trustworthy tool, usually
I got the idea for identifying doomed stocks from Barron's, the venerable weekly stock-market magazine. In the mid-1990s, Barron's ran occasional articles identifying stocks it thought were overpriced and due for a fall.I tracked the performance of Barron's overpriced stocks. Some continued to outperform, but as a group, Barron's overpriced portfolios usually substantially underperformed the market over the next six to 12 months.
Barron's described the formula it used to identify overpriced stocks. So rather than reinvent the wheel, I adopted Barron's formula for my own use. I periodically tracked the performance of my doomed-stocks portfolios. They continued to consistently underperform against the market through 1998. Then, everything changed.
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Starting in 1999, instead of underperforming, my doomed stocks consistently trounced the market and even the red-hot Nasdaq Composite Index ($COMPX). Those were the bubble days, of course, but I didn't realize it at the time. So, I decided the doomed-stock formula no longer worked and stopped using it. We all know what happened next.
Later, I resurrected the formula, describing it in an MSN Money article. Even though Barron's probably picked its criteria more or less arbitrarily, it worked. So I used the original formula with only one change, which I'll describe when I get into the details. For the article, I ran a screen in early June 2004 that turned up 15 doomed stocks.
When I checked the results a year later, I found that the doomed-stocks formula had gotten its mojo back. The portfolio had averaged a 16% loss compared with a 7% gain for the S&P 500 Index ($INX), and 13 of the 15 stocks had registered losses.
Here's how to see if your stocks are doomed. To qualify as doomed, a stock must meet all four criteria.
1. Share price doubled in 12 months
The fact that a stock has already made a big move up marks it as potentially doomed.Barron's defined doubling over the previous 12 months as a big move. You can find the past 12 months' price change listed in the Stock Price History section of MSN Money's Company Report.
2. Price-book ratio at least 5
The price-book ratio is the recent share price divided by book value or shareholders' equity expressed on a per-share basis. Most growth-priced stocks trade with price-book ratios above 3.The last time I checked, more than 1,000 stocks sported ratios above 5. You can find the P/B and other valuation ratios under Key Ratios in the Financial Results section of MSN's Company Report.
3. Forward price-earnings ratio at least 40
Here's where I did change Barron's formula. As you probably know, the price-earnings ratio is the recent share price divided by 12 months' earnings. But, not everyone uses the same 12 months' earnings to calculate P/E.Barron's used the trailing 12 months, which is the previous four quarters' reported earnings. For my June 2004 column, I changed the formula and calculated the P/E using analysts' current fiscal year's forecast earnings.
At first blush, the trailing 12 months' earnings sounds like a better choice because it's based on real numbers instead of analysts' wishful thinking. But trailing earnings are often reduced by charges related to acquisition costs or other one-time events. Since the lower the earnings figure, the higher the P/E, those one-time charges artificially inflate the P/E. To me, it doesn't make sense to value a company based on 60-cent-a-share historical earnings if it's expected to earn $1 per share this year.
The P/E ratio calculated using this year's forecast earnings is called forward P/E, and it's listed in the Earnings Estimate section of MSN's Company Report.
In my June 2004 article, I left the P/E threshold at 50, which is what Barron's used. But, on further contemplation, I decided that I should have reduced that figure. Since, by definition, growth stocks' earnings are expected to grow, the forward P/E will always be lower than the P/E based on trailing earnings.
Probably most potentially overheated stocks are expected to grow earnings by at least 20 percent annually. So, for this version, I cut the forward P/E threshold to 40. When I checked, fewer than 300 stocks had forward P/Es above that level.
4. Price/sales ratio at least 5
The price-sales ratio is similar to P/E except that the recent price is divided by 12 months' sales per share instead of earnings (the trailing 12 month's sales figure is always used for P/S). Since quarterly sales usually don't fluctuate as much as quarterly earnings, P/S is considered a steadier valuation gauge than P/E. Price-sales ratios for growth stocks typically run in the 4 to 8 range, and when I checked, more than 1,400 stocks had ratios above 5.Here's a link to the screen that lists stocks that currently qualify as doomed stocks. The screen turned up 14 stocks when I ran it a while back, during a weak market. It would probably list 25 to 40 stocks, or even more, in a stronger market.
Don't expect the doomed stocks to dive immediately. The screen works best for identifying stocks likely to trade lower six to 12 months into the future. Even then, not all stocks will drop. In my June 2004 screen, one stock, Immucor (BLUD, news, msgs), more than doubled over the following 12 months.
| Company Name | Industry name | Last price | % price change past year | Forward year P/E | Price/sales ratio |
|---|---|---|---|---|---|
Internet Software & Services | 33.16 | 127 | 102 | 16.3 | |
Gold | 5.27 | 129 | 759 | 17.5 | |
Biotechnology | 48.07 | 103 | 122 | 27.3 | |
Resorts & Casinos | 52.5 | 109 | 59 | 22.1 | |
Advertising Agencies | 65.84 | 238 | 46 | 36 | |
Gold | 38.05 | 129 | 49 | 20.4 | |
Beverages - Soft Drinks | 50.59 | 278 | 42 | 10.3 | |
Medical Appliances & Equipment | 45.87 | 129 | 52 | 6.1 | |
Biotechnology | 28.87 | 101 | 197 | 13.6 | |
Medical Appliances & Equipment | 114.78 | 120 | 67 | 15.4 | |
Internet Information Providers | 19.48 | 175 | 46 | 8.1 | |
Specialty Chemicals | 23.31 | 174 | 607 | 6.2 | |
Gold | 10.09 | 151 | 47 | 34.2 | |
Industrial Electrical Equipment | 27.44 | 141 | 179 | 7.9 |
My doomed-stock formula is intended to alert you to grossly overheated stocks. Just because it doesn't qualify as doomed doesn't mean that your stock is worth buying. You still have to do your due diligence.
At the time of publication, Harry Domash did not own or control positions in any of the stocks mentioned in this article.
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