Investors who can precisely differentiate between overpriced stocks and fairly priced stocks emerge winners. However, in this complicated market place, these two types of stocks are intertwined in such a way that it is very tough to identify them. Investors who can pick the toxic stocks appropriately and abandon them at the right time are likely to benefit.
Generally, the overblown toxic stocks are susceptible to outside shocks and are loaded with high levels of debts. Also, the price of the toxic stocks is unrealistically high. The irrationally inflated price of the toxic stocks is only short-lived in nature as their intrinsic value falls short of the current hyped price.
The overhyped price of toxic stocks can be attributed to either an irrational exuberance associated with them or some fundamental drawbacks associated with the stock. Owning such stocks for a long period of time is detrimental and may lead to huge erosion of wealth.
On the other side, investors may gain from the accurate identification of toxic stocks with the help of an investing strategy called short selling. This strategy allows you to sell a stock first and then buy it when the price falls.
While short selling excels in bear markets, it typically loses money in bull markets.
So, figuring out toxic stocks and discarding them at the right time is the key to protect your portfolio from big losses. Profits can be made by short selling them.
Here is a winning strategy that will help you to identify overpriced toxic stocks:
Most recent Debt/Equity Ratio greater than the median industry average: High debt/equity ratio implies high leverage. High leverage indicates a huge level of repayment that the company has to make in connection with the debt amount.
P/E using 12-month forward EPS estimate greater than 50: A very high forward P/E implies that a stock is highly overvalued.
% Change in F (1) and F (2) Estimate (12 Weeks) less than -5: Negative EPS estimate revision for this and the next fiscal year during the past 12 weeks points to analysts’ pessimism.
Zacks Rank more than or equal to #3 (Hold): We have not considered Buy-rated stocks that generally outperform the market.