One of the most satisfying experiences in your investing life is find a stock that provides a huge return over time. As a value investor, I love finding a stock whose fair value is rising faster than the price, and the stock ends up appreciating to many times the original purchase price.
These are the stocks that keep you above the market over time.
Of course, as important to your investment success as it is to find these fairly valued winners, it’s equally vital that you avoid the losers, which destroy capital.
As we all know, stocks can fluctuate wildly during the course of any given week, month or year, but if the business value doesn’t change, odds are high the price will recover to reflect the value of the underlying company. So it’s when you speculate in stocks where the price has no connection whatsoever to the actual value of the company that you face a permanent loss of capital that destroys your long-term returns.
If you want to know what a permanent loss of capital looks, like consider Cisco (CSCO) at over $80 a share back in the late ’90s and Microsoft (MSFT) over $100 in 2000. The valuation of the stock was insanely high due to the popularity of tech and internet stocks and the shares now trade at a fraction of the price paid back then. Buyers of the stock at the height of the frenzy are unlikely to live long enough to fully recover their initial investment.
Also look at banks like Citigroup (C) and Bank of America (BAC) in 2007. The stocks traded at valuations higher than the norm for bank stocks, and there were so many moving parts and off-balance-sheet arrangements on the books, it was almost impossible to figure out what the shares were worth as a business. Investors who ignored the deteriorating condition of these banks as real estate prices began to fall will probably never see the original purchase price again in their lifetime.
Much like we advocated for using the Piotroski F-score — an examination of the financial statements that helped identify potential winning value stocks from value traps — to find good stocks, we also can use it to find potential capital destroyers. The research shows that stocks trading at very high multiples of earnings and asset value with high F-scores are vulnerable.
When I ran the screen this morning, some surprising stocks were on the list.
Netflix (NFLX) has been a stock market star for the past year, more than tripling so far in 2013. However, with NFLX trading at 300 times trailing 12-month earnings and almost 100 times forward earnings, it’s hard to say that you’re actually investing in a business. It’d be more accurate to say you’re betting on a popularity contest. Even worse, you’re betting on a beauty queen whose makeup is fading. Netflix has a below-average F-score of 4, indicating that the fundamentals of the business might be slipping.
Investors and traders have piled into shares of Zillow (Z) this year as the provider of real estate information services was positioned as the perfect way to play a real estate recovery. The stock now trades at 180 times the most optimistic analysts estimates for the next year and is richly valued when you look at actual and potential growth rates. And the F-score for the company is just 4 indicating, that the picture might not be as pretty as the story being told.
As of this writing, Tim Melvin did not hold a position in any of the aforementioned securities.