This Chart Pattern is Signaling a Sell-Off for This Stock

Occasionally, I sort stocks by price-to-earnings (P/E) ratios looking for trading opportunities. This idea is well-known to value investors who often start their investment selection process with low P/E stocks.#-ad_banner-#

I think it can be useful to flip that idea around and look at the stocks with the highest P/E ratios. Sometimes that list will include rapidly growing companies that are shaping consumer and industrial markets. Lists of high P/E stocks will also almost always include stocks that make great short candidates or offer trading ideas based on put options.

There are at least 10 stocks with a market cap of more than $400 million and a triple-digit P/E ratio based on earnings from the past 12 months and forecasted earnings for the next 12 months. One of these seems to be an especially appealing trading candidate, Wright Medical Group (Nasdaq: WMGI).

Wright makes medical devices used in ankle, knee and hip surgery. The company believes it can be a market leader in products used for foot and ankle surgery, and recently completed an acquisition that could help it deliver growth in that area.

This is a $3.7 billion market, growing 8-10% a year, according to company estimates. Wright expects to be able to deliver above-average growth in this market segment, which makes up about 40% of the company’s current sales. The majority of sales presently come from products made for hip and knee surgeries, an area with almost no projected growth. 

This could be a good long-term strategy. Wright expects to move from a slow growing market and expand into a faster growing market. The numbers look good for Wright, assuming the company can meet its sales and profit targets, but the stock price seems to have gotten ahead of the fundamentals.

For 2012, Wright is expecting revenue of about $480 million. The company reported earnings of 69 cents a share in 2011, and analysts expect earnings per share (EPS) of 21 cents this year and 11 cents next year. The stock is trading at about $20.65 giving it a P/E ratio of 737.5 based on EPS in the past 12 months and 188 times next year’s estimates.

Analysts expect sales growth of about 1.4% next year and average annual earnings growth of 10.1% during the next five years. Fifteen Wall Street analysts have assigned a rating to the stock and 10 deem Wright a “hold.” Very few stocks are rated “sells,” meaning that hold is generally the lowest rating a firm will assign to a stock.

The company does have a significant amount of cash, about $8 a share, on its balance sheet. The book value of $13.23 a share might be a good target based on the fundamentals for now.

The technical picture backs up the fundamentals and points to a possible decline in the price of Wright.

The stochastics indicator is bearish on the monthly and weekly time frames shown above. A head-and-shoulders pattern is visible on the weekly chart with a downside target of about $17, almost 18% below the recent price. Additional downside is possible given the weak fundamentals.

Put options offer a way to profit from a decline in Wright without shorting the stock. Puts with a strike price of $20 expiring in February are trading for about 85 cents. If Wright reaches $17, then these puts would be worth at least $3.

Companies that have P/E ratios above 100 are rarely good investments and Wright seems like a company trading well above its fair value. This is a low-risk trade based on the small dollar amount required to open a position. The potential rewards are twice as great as the risk.

Action to Take –> Buy WMGI Feb 20 Puts for $1 or less. Do not use a stop-loss. Set initial price target at $3 for a potential 200% gain in two months.

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Chart Pattern Signaling a Sell-Off That Could Make You 200% Profits