A Pullback Is Coming: Dump These Momentum Stocks First
With the market at or near its all-time highs, a number of renowned investors and market commentators have been questioning the market’s valuation over the past month or so.
#-ad_banner-#Billionaire Carl Icahn is the latest to grow wary of the market. “In my mind, it is time to be cautious about the U.S. stock markets,” he said last week.
So how do investors prepare for a pullback? The first group of stocks to avoid is the momentum names, which trade on investor optimism, not on the strength of their fundamentals. Stocks that trade at outrageous valuations are often the first to be sold if the market takes a turn downward.
Icahn isn’t alone in his caution. Fellow billionaire David Einhorn is short a basket of stocks that trade at outsize valuations. In a Bloomberg interview earlier this year, Einhorn hinted that his targets to short include tech stocks with negligible earnings that are trading above 10 times sales.
Among the stocks that fit this bill are Twitter (NYSE: TWTR), TripAdvisor (Nasdaq: TRIP) and Zillow (Nasdaq: Z).
All three have price-to-sales (P/S) ratios above 15, and all three appear to be trading on irrational exuberance. Since the last major pullback in February, shares of TripAdvisor and Zillow have been on a tear. Twitter is still under pressure after investors dumped the stock on fears of slowing growth.
The Beaten-Down Social Stock
If the market sees another pullback, Twitter will likely be in for more pain. Down 15% from its IPO debut last year, Twitter still trades at the highest P/S ratio of the three, coming in at 28. It also trades at a forward price-to-earnings (P/E) ratio of 145 based on next year’s earnings estimates.
Adding to the many unanswered questions about Twitter’s business model, the company still lacks any meaningful diversification of its revenue, and the competition for advertising dollars has been heating up. Not surprisingly, market research firm eMarketer expects Twitter will trail both Facebook (Nasdaq: FB) and Google (Nasdaq: GOOG) in mobile ad revenue growth this year.
Twitter’s revenue has instead relied on expanding its user base and increasing user engagement, which slowed in its most recent quarter. The rise of other social networks may only put further pressure on Twitter’s growth.
Solid, But Poised For A Pullback
At the end of April, I noted that TripAdvisor was the only momentum stock that investors should own. Shares are up over 35% since then, compared with the S&P 500 Index’s 5% gain. However, TripAdvisor may be one of the momentum names that feels the most pain in a pullback.
It is the only one of these three companies with positive earnings, but its P/E and P/S ratios are still high at 72 and 15, respectively. The company relies more heavily on ads than bookings, which are the focus on Priceline’s (Nasdaq: PCLN) and Expedia’s (Nasdaq: EXPE) business models. Like Twitter, TripAdvisor is seeing increased competition in the ad space, and the broader shift toward mobile may mean less ad revenue for the company, given that mobile ads are proving less effective than desktop ads.
The Highly Shorted Real Estate Play
Zillow is heavily exposed to real estate sales and has been benefiting from the resurgence in homebuying. If the housing market recovery has already played out, it’s not just homebuilders that will feel the pressure — side plays like Zillow (and its online real estate database service) likely will, too.
Jeffrey Gundlach, the CEO of investment management firm DoubleLine, is one of the market’s biggest bears on the housing market. He noted at this year’s Sohn Investment Conference that single-family housing is overrated. He also pointed out that a small rise in rates earlier this year has already hurt the housing market, and further increases will likely further weigh on home sales.
What’s more, short-seller research firm Citron has been pointing out Zillow’s flaws for a number of years. One of its criticisms has been that Zillow has been spending too much on sales and marketing to rev up sales. In one report last year, Citron asked: “Zillow spent more getting revenue than the revenue itself. Is this a business?” Between its 2013 and 2014 fiscal years, Zillow increased its spending on sales, general and administrative (SG&A) expenses by $14 million — but its revenue rose by only $8 million.
With a P/S ratio of 23 and a forward P/E of 155, Zillow remains one of the most shorted names in the market, with a short interest ratio of nearly 32%.
Risks to Consider: These momentum names could well run higher before seeing a sell-off. Twitter has already been beaten down quite a bit, and it could attract growth investors if it posts solid growth numbers in its next quarter. TripAdvisor is adding subscription revenue to its business, which could decrease its reliance on ads more quickly than expected. Zillow could also expand its rental business faster than expected and capitalize on the shift from buying to renting.
Action to Take –> Sell (or short) these 3 stocks before the inevitable market pullback. All three trade at high valuations and will likely be among the first names that investors dump during a correction.
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