I use the P/E Gap for identifying long- and short-term trading opportunities. The approach finds stocks trading inefficiently by comparing a stock’s price-to-earnings ratio to its expected profit growth rate.
It’s helped me spot several overvalued turkeys that need to go on the block now.
When the gap is negative – the P/E ratio is smaller than the expected profit growth rate – a stock is said to be undervalued. The reverse is true when the P/E Gap is positive – which occurs when the P/E ratio is higher than the expected profit growth rate. These are the stocks to sell and sell quickly.
Tesla (TSLA) is a good example. Tesla shares have been in a free-fall after brushing up against $200 per share in September. The headlines for Tesla’s stock collapse have focused on disappointing earnings and the more sensational fires that have suddenly plagued the new car company. Both are true, but the P/E Gap suggested this one was due for a major collapse. Tesla’s valuation can’t be supported by operations. It’s that simple and the PE Gap can help you sniff that out.
With Thanksgiving upon us, I thought it might be appropriate to identify the P/E Gap turkeys. These are stocks that jumped out at me when I last ran my P/E Gap calculations at the end of October. While two of the three stocks below have indeed gone down in value in November, they are still overvalued.
Sell these turkeys now before it’s too late:
CubeSmart (CUBE) is a real estate investment trust. Typically, I exclude such stocks from my P/E Gap analysis, but not in this case. The company is overvalued plain and simple and should be sold. Yes, there is a dividend here, but not enough to justify the premium in the stock. The company is in the self-storage business – a sector that did particularly well during the financial crisis and extraordinarily high foreclosure rate.
Since bottoming near $1 per share in 2009, the stock has been on a straight shot higher. It started selling off in late October and was picked up by my P/E Gap model at the end of the month. Selling has accelerated in November and I expect even more losses. Chartists will see a head-and-shoulders pattern developing signifying a possible collapse. Analysts expect profits to grow by 11% in 2014. At current prices shares trade for 17 times 2014 estimated earnings. This is a classic P/E Gap story that should be sold.
Large pharmaceutical companies like Merck (MRK) are to be avoided at all costs in this market. There is simply no reason to own the stocks. Those who have been bidding up shares have done so in pursuit of a dividend. All that buying has made the stocks expensive.
With respect to Merck, there is little innovation on the horizon and with previously patent-protected drugs coming off-line, there is a risk for profits to fall. At the moment analysts expect Merck profits to be flat in 2014. At current prices, shares trade for 13.5 times 2014 estimated earnings. Don’t be fooled by the near 4% dividend. This one is likely to lag the market in the short term.
United States Cellular
The cellular business has been a popular safe haven for defensive investors. The reliable and often growing cash flows of these businesses have made them an attractive investment. Shares of United States Cellular (USM) have appreciated nicely since bottoming this past summer.
United States Cellular’s valuation doesn’t hold, up in my opinion. Analysts expect profits next year to move from a small profit to a small loss. That’s a bad sign. At current prices, shares trade for more than 100 times 2013 estimated earnings. Sometimes the market just makes little sense, as is the case here. I would be a seller of this turkey sooner than later.