A major surge in any given stock can help pump up a portfolio's returns, and for many investors, holding tight on a winning stock pick seems like the right thing to do. After all, the news has been good (perhaps in the form of raised guidance or a savvy acquisition) and should remain positive in the months ahead.
Yet it's crucial that you provide a fresh, deep assessment on these winning picks. What was once an undervalued opportunity may have slowly drifted into overvalued territory. Let's look at Lumber Liquidators (NYSE: LL) as an example. This maker of flooring has seen its stock rise a stunning 180% during the past year, thanks in part to solid quarterly results and also to a general sense that a new home construction boom is about to begin.
Not only has this company been able to boost sales at a double-digit pace for nearly a decade, but sales are expected to grow another 10% to 12% in 2013 and 2014 as well. And analysts think that earnings per share (EPS) will surge from $1.68 in 2012 to near $2.40 by 2014.
Yet by a host of measures, valuations have started to move into nosebleed territory. For example, the company is now valued at around two times sales, even though its EBITDA (earnings before interest, taxes, depreciation and amortization) margins will never be much above 10%. Companies with such low EBITDA margins often trade closer to 1 or 1.5 times sales.
Said another way, Lumber Liquidators' enterprise value (which equals a firm's market capitalization plus total debt minus cash) now stands at nearly $1.8 billion, or more than 20 times trailing EBITDA. Few stocks ever trade that richly.
This is clearly an impressive company that plays a strong role in a fast-growing industry. But investors are seemingly ignoring key concerns such as margin pressures and constraints on cash flow generation. Cree is a perfect example of a company you want to own after it has delivered a bad quarter or two.
I thought Cree was a great investment in early 2012, when shares were trading in the low $20s, but the move up into the $50s means the company must keep delivering great quarters -- including firming profit margins -- or investors will put it right back into the penalty box, as was the case in 2011.
For some investors, the time is nearing to again look at short-selling candidates. The market's steady upward move has pushed fearful short sellers to the sidelines, but a sideways or down market will bring short-selling right back into vogue.
If you're looking for short-sale candidates, there are two ways to skin the cat. The first is to look at the market's top-performing stocks during the past year, many of which have benefited from solid quarterly results but also a rising market tide that has given momentum to stocks that already have high momentum. The so-called relative strength approach to investing has been a solid strategy in recent quarters, though that momentum angle eventually peters out.
With that in mind, here are the 12 highest-performing stocks in the S&P 400, 500 and 600 (all of which have a forward price-to-earnings (P/E) ratio of at least 20) during the past 12 months.
The second way is to look at this group of stocks from a different angle, focusing on those with the highest P/E ratio (based on 2014 profit forecasts) that have risen at least 50% over the past 12 months. The fact that these stocks sport forward multiples that are well above the market average will make them ripe for selling once the market hits an air pocket and investors seek to prune their portfolio of the most richly valued stocks.
This will be an interesting group of stocks to track during the remainder of 2013. In a sideways market, they may underperform simply because better values abound. And in a falling market, their lofty valuations may lead some of these recent winners on a sharply downward path.
Risks to Consider: The market is still rallying as we head into earnings season, and in keeping with Newton's First Law of Motion (a body in motion tends to stay in motion), these momentum plays could be swept yet higher until the market cools.
Action to Take --> As we head into the fifth year of a robust bull market, it's imperative you pay attention to valuations. It's wiser to focus on value-oriented stocks, as they not only possess potential upside but better downside protection if the market gets choppy. If you own any of these fast-rising stocks mentioned in this column, you should closely monitor their upcoming conference calls to be sure you still see further upside ahead.