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Avoid Risk to Prosper

As previously noted, there are a growing number of very smart investors and strategists who have made negative comments about the stock market in recent months.

James Montier, Seth Klarman (Trades, Portfolio), Carl Icahn (Trades, Portfolio) and a host of other very smart investors have pointed out that the market is on the high side of fair — and investors are exposed to a good chance of significant losses and low forward returns.

All of them have also added an addendum, that warns that no one knows when the market will roll over and revalue. It is quit possible the stock market rides the low interest rate wave for many more points before readjusting to economic reality. But anyone who was around for the Internet bubble knows that you can look quite foolish for a long period of time before being acknowledged as a prophet in the stock market.

This creates quite a puzzle for investors. No one wants to miss a rising market, but no one wants to be around for the crash, either. As the market moves higher, stock selection becomes incredibly important. Investors should focus only on those stocks that pass the test of being safe and cheap, and be diligent to sell those that have reached fair value.

Even more important is avoiding stocks that have a real risk of a permanent loss of capital. These are those issues that have rallied sharply, but the numbers and fundamentals do not hold up under closer scrutiny. If the markets do roll over, it is highly likely that these stocks will lead the way lower when we do get a market readjustment.

Dish Network (DISH) is a great example of a stock that appears to carry a lot more risk that reward potential right now. The story with Dish is that the stock in “in play,” and likely to merge with DirecTV (DTV) or AT&T (T) to more effectively compete in the crowded cable and satellite television space. The chatter has picked up of late in the wake of the Comcast (CMCSA) and Time Warner Cable (TWC) merger announcement. It may happen, but at what price would a deal occur?

Dish shares trade at more than 30 times earnings and 2.6 times book value. The enterprise value to EBITDA ratio is over 11, and most buyout pros consider a single digit ratio to offer the most potential. What happens if the FCC just says no to a deal? The company earns an F-score of just five, so fundamentals are just so-so for this company right now. There would appear to be limited upside with lots of potential catalysts for the stock to move a lot lower in a falling market.

Continental Resources (CLR) shares have a fantastic run, rising 56 percent over the past year. The company is the leaseholder in the Bakken shale and has been growing its oil and gas production at a very high rate. The stock has been pushed higher this year on hopes for expedited oil and gas exports to Europe.

When we look a little closer, investors are paying a very high price for the hope of continued high production growth and a faster opening of export markets. The stock is trading at 30 times earnings and 5.67 times book value at a time when many of their competitors trade at single-digit P/E rations and for less than asset value. The F-score is just three, so fundamental and overall financial conditions are not improving year over year.

Zillow (Z) has benefited enormously from the real estate recovery. Sales and earnings, as well as the stock price, have soared the past few years — as brokers, buyers and investors turned to the company's web sites for guidance and information about real estate markets.

They have seen their stock price almost triple off the lows, and the stock has now reached what would be very dangerous levels if the tone of the market turned. The shares trade at 130 times hoped-for earnings, six times book value and 19 times trailing 12-month revenues.

The F-score of three tells us the high growth rates are likely to be moderating going forward. If they were to miss the highly accurate Wall Street earnings estimates or the market corrected, this stock could cause a permanent impairment of capital for shareholders that buy at the current very high price.

It is impossible to know in advance when and why the market might change direction. It is possible, however, to identify those stocks with high valuation levels and poor fundamental measurements that would expose one to excessive losses when the course of the market does finally changes direction.

The industry continues to present opportunities for value investors who can weed through the daily noise of the market. A perfect example is the 3 Low Risk, High Yield Stocks that Tim Melvin identifies as the trades of the decade.

© 2014 Benzinga.com. Benzinga does not provide investment advice. All rights reserved.

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About the author:

Tim Melvin
Tim Melvin is a value investor, money manager and writer. He has spent the last 27 years as in the financial services and investment industry as a broker, adviser and portfolio manager. He has also written and lectured extensively on the markets with his work appearing on RealMoney.com, DailySpecualtion.com, Benzinga.com as well as several print publication including Active Trader and the Wall Street Digest.

Visit Tim Melvin's Website


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