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Highly overpriced stocks likely to not be worth the risk

Why do people do it?

Investing on hope is a natural impulse. But when you take it to an extreme — such as putting money into a stock that sells for 100 times revenue per share — you are asking for disaster.

Since 2000, I have compiled 10 warning lists of stocks that sell for such extreme valuations (2000-2006 and 2012-2014). As I predicted, most of them have done terribly.

On average, these stocks have suffered a decline of 36.5 percent in the 12 months following publication of my columns.

By contrast, the Standard & Poor’s 500 Index has risen an average of 8.6 percent in the same periods.

Eight of my 10 warning lists showed a decline, and nine of the 10 underperformed compared to the S&P 500.

72 percent decline

Last year I warned against five super-pricey stocks. Here are the results:

• Intercept Pharmaceuticals (ICPT) has fallen 42.7 percent.

• Lexicon Pharmaceuticals (LXRX) has declined 52.9 percent.

• Ubiquity Broadcasting Corp., now Ubiquity Inc. (UBIQ) is down 69.4 percent.

• SunGame Corp. (SGMZ) has dropped 94 percent.

• Gawk Inc. (GAWK) is now valued at zero after a 100 percent decline.

Collectively, these stocks lost 71.8 percent of their value.

The figures are total returns including dividends for the period February 18, 2014 through February 13, 2015. During that time, the S&P 500 Index gained 16.3 percent.

Be aware that past performance may not predict future results.

The performance of my column recommendations is theoretical, with no impact from trading costs or taxes. And the results of my column picks shouldn’t be confused with performance I achieve for clients.

New warnings

Here is a new list of stocks to avoid, each of them trading for 100 times per-share revenue or more.

For most readers, this is a list of stocks to avoid. If you are a short seller (one who bets on selected stocks to decline), it may be useful as a candidates list.

Acadia Pharmaceuticals Inc. (ACAD) is a San Diego biotech company working on medicines that may combat neurological conditions such as Alzheimer’s disease and Parkinson’s disease. Its drugs are in Phase II and Phase III clinical trials.

Naturally, everyone hopes for a breakthrough against these diseases.

But I think the numbers make this stock a poor bet. Its market value is $3.4 billion. The company’s revenue in the past four quarters was about $104,000.

The gives Acadia a price-to-revenue ratio of 30,974. By comparison, the average stock today sells for about 2.1 times revenue, and even that is elevated by historical standards. IBM sells for 1.7 times revenue. Microsoft’s multiple is 3.8.

In my opinion, Acadia will need time to grow into its present valuation if its new drugs are successful. If they’re not, the stock is a ticket to oblivion.

Promises, promises

Armour Residential REIT Inc. (ARR) of Vero Beach, Fla., has an infinite price-to-revenue ratio because it has no current revenue. It does, however, own some $15 billion of mortgage-backed securities.

Analysts expect Armour to show a profit this year, but it posted a loss in 2013 and in two of the first three quarters in 2014.

I have sold Armour shares short (betting on a decline) in one client account.

Accelerate Diagnostics Inc. (AXDX) of Tucson is trying to develop and sell products that allow rapid identification of infections, to allow prompt life-saving treatment.

It is not there yet. Revenue in the past four quarters was about $55,000. Yet the company’s market value is $1 billion, giving it a price-revenue ratio of 18,712. I believe that this stock, like Acadia’s, is ahead of itself.

Neuralstem Inc. (CUR), is a biotech outfit with headquarters in Rockville, Md., working on treatments for (among other things) amyotrophic lateral sclerosis (Lou Gehrig’s disease) and depression.

Again, the causes are worthy and the potential markets large. But again, the stock is anticipating the best case, selling at 17,192 times revenue.

Math lesson

Why is it so dangerous to invest in a stock selling for 100 times earnings? It’s simply a matter of math.

The average stock over the years has sold for about 15 times earnings — that’s earnings, not revenue.

Take a stock that sells for 100 times revenue. Assume that revenue grows ten-fold, or 1000 percent. Further assume that the company achieves a 25 percent profit margin (vs. 8.5 percent for Exxon Mobil, 10.3 percent for General Electric, and 22.3 percent for Apple).

After all that, the stock would be selling for 40 times earnings, quite a hefty multiple.

Can it happen? Yes. Do the odds favor it? No.

John Dorfman is chairman of Dorfman Value Investments LLC in Boston and a syndicated columnist. He can be reached at [email protected].


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