Look out Below: These Stocks are Headed Down

In search of undervalued companies, investors seek out stocks that tend to have an earnings growth rate that is higher than the price-to-earnings (P/E) ratio. These stocks are known as low PEG stocks, or stocks with a PEG ratio below 1. (For example, a P/E of 10, and an earnings growth rate of 20% yields a PEG ratio of 0.5, or 10 divided by 20).

Well, the converse is also true. Companies with a high PEG ratio can be overvalued. If you hold a stock with high PEG ratio, you may want to contemplate selling the shares. Better yet, high PEG stocks sometimes also make compelling short selling candidates.

So I went looking for companies that have a P/E ratio that is at least twice as high as the earnings growth rate. In other words, they have a PEG ratio above 2.0. On the table below, I’ve compiled a list of high P/E stocks that show either small or negative profit growth forecasts for 2011. For most on this list, profit growth is expected to turn negative next year, but the basic concept of a too-high PEG ratio still applies.

Akamai Technologies(Nasdaq: AKAM) appears to be a poster child for high PEG stocks. The provider of content delivery services is a good — not great — growth story. Over the years, an increasing number of companies have relied on Akamai to store content in local servers so websites can be pulled up quickly anywhere in the world. After years of erratic growth, the company is on track to boost sales and profits about +15% in 2011. Yet this has become a largely mature industry, price pressures are starting to bite, and the major telecom players are trying to steal market share, which is why analysts don’t expect profit growth to exceed +10% to +15% in 2012 and beyond.

So why do shares trade for 33 times projected 2011 profits? Or said another way, does this stock deserve a PEG ratio above 2.0? Probably not. Instead, this is a classic example of a stock that becomes so hot that it becomes disconnected from the fundamentals. Investors have been bidding up shares in the expectation that a suitor for the company might emerge. Yet the higher shares rise, the harder it would become for a suitor to acquire the company without taking a big hit to its earnings per share (EPS), as any deal would likely be quite dilutive. So if a deal fails to materialize, or investors start to see Akamai as a slowing-growth kind of company, then the high P/E ratio would set shares up for a big fall.

It’s worth adding that Limelight Networks (Nasdaq: LLNW) and InterNAP (Nasdaq: INAP), a pair of Akamai rivals, also make this list. Each stock carries a super-high P/E ratio, which would be understandable if each company was just getting going. But this is a mature industry, and these companies are likely to only grow in single digits in 2012 and beyond. So it’s hard to see how earnings will grow fast enough to ever justify such a lofty P/E ratio.

The earnings look back
At first glance, it makes sense that boat builder Marine Products (NYSE: MPX) sports a very high P/E ratio. Boat sales are depressed and profits will be more robust when the economy improves. Back in 2005, the company earned a record $0.65 a share, and the stock trades for about 10 times that figure. But that was a peak year. In the past 10 years, annual EPS has averaged $0.30. And shares don’t deserve to trade at 20 times average annual earnings, since this is a highly cyclical business. This stock has nearly doubled since the summer of 2009, but it looks as if investors are over-estimating the prospects of robust profits in the future.

A high-growth P/E for a low-growth company
Perhaps no company on this list better typifies the perils of a high PEG ratio than retailer Sears Holdings (Nasdaq: SHLD). Profits are going nowhere, but you can’t just blame the weak economy. Management has spent the past five years squeezing cash out of this business, leaving Sears and Kmart stores badly in need of sprucing up. As analysts at research firm ISI noted in a recent report, Sears Holdings generated no free cash flow in the first half of 2010, but still bought back $273 million in stock. Their conclusion: “We continue to believe that underinvestment will not support the asset base and find much better opportunities (elsewhere) in retail.” They see shares falling from a recent $73 down to $52 as they predict that current consensus profit forecasts are too high.

Analysts at UBS see shares falling down to $56 and rate the stock a “sell.” They have a point — shares trade for more than 30 times UBS’s 2011 profit forecast.

Action to Take –> The only time you can justify a high P/E ratio is when a company has not begun to reap the benefits of projected strong growth. But the companies on this list are largely mature, and unlikely to see a big spurt in profits down the road. Sears Holdings in particular carries the value of a hot tech stock but is really a lumbering giant whose best days have passed. If you hold any of these stocks, consider selling. And for those investors looking for a short candidate, the list above is a good place to start.

P.S. — Any analyst can tell you they like a stock. But how many are willing to put their money where their mouth is? StreetAuthority Market Advisor is so confident in Nathan Slaughter’s picks that we gave him $100,000 in cash to put into his recommendations. Learn how you can join in and profit along with him.