No one wants to be caught owning what the pros refer to as a “value trap”—an irresistibly cheap stock that appears to have tremendous upside potential. The problem? It just gets cheaper and cheaper with every day that passes.
Some market veterans refer to these investments as roach motels: You can buy the stock, but you can never get out again at anything approaching a break-even price.
Value traps have their counterparts at the other end of the spectrum: stocks that look pricey and appear to be excellent candidates for selling short, or at least shunning. Yet, regardless of what your research and your common sense suggest, these stocks don’t see their stock prices plunge. Quite the contrary: They climb still higher, in apparent defiance of the laws of gravity.
Price/earnings ratios that you already thought were rich get even more outlandish. Anyone who decided to sit on the sidelines starts to suffer a case of buyer’s remorse, while those who opted to short the stock get squeezed out, usually at a big loss.
These are stocks with sex appeal – the kind that some investors find irresistible, or lust over, even against their better judgment.
Perhaps because of this year’s hefty market gains, the market seems full of stocks like this right now. Sex appeal traps tend to be companies that offer investors a great “story” to offset the less-than-appealing fundamentals or slightly surreal valuations. Investors don’t just buy; they become true believers in the concept. While a value trap investor might legitimately make the case that he isn’t wrong, just early, the victim of the typical sex appeal trap is clearly behaving foolishly.
There are a few hallmarks that characterize these sex appeal traps, over and above lofty valuations and often high short interest. Very often, these are businesses with a big profile among the general public, or ones that offer products that individual investors like and figure must be worth money, somehow. Amazon (NASDAQ: AMZN) is one oft-debated example. Here are five others.
Tesla Motors (NASDAQ: TSLA): There aren’t many stocks out there that shorts love to hate as much as this one – and for good reason. The concept of an electric car may be a long-term winner (although it’s not as green as some like to believe as long as we’re burning coal to generate electricity to power these cars), but for the time being, Tesla’s costly automobiles aren’t selling in nearly the kind of quantity required to justify its valuation.
Tesla trades at more than 100 times forecast earnings, although since it has been reporting losses until recently, there really isn’t a P/E ratio we can talk about. The stock is up 511 percent in the last 12 months, even though its loss before interest, depreciation and taxes (EBITDA) has grown with each year in the last five full years.
Of course, it’s impossible to tell how much of that impressive gain can be traced to a particularly painful short squeeze, as bears have been forced to buy back the stock they had sold short and cover their losses. If anyone ever needs an example of the way in which Wall Street responds not to what has happened but to what market participants believe will happen next, all you have to do is point them toward Tesla Motors.
Netflix (NASDAQ: NFLX): Delivering entertainment content to our various devices – laptop, tablet, smartphone – is hardly a business with a high competitive moat. In fact, we’ve got options and lots of ‘em, ranging from Amazon’s (NASDAQ: AMZN) store to Google’s (NASDAQ: GOOG) YouTube, from Hulu.com to Apple’s (NASDAQ: AAPL) iTunes.
What makes Netflix stand out? The company has staged a big turnaround and increased its subscriber base – that’s reasonable enough. A little less reasonable is the 349 percent gain in the company’s stock price, which has left it trading at about 360 times earnings.
Why has Netflix regained its sex appeal? Well, it is developing its own content and offering users the ability to “binge view” their favorite new series (or watch all the episodes of a given season over a day or a weekend), thanks to deals with studios and production companies. Right now, Netflix is offering its subscribers the hit “Orange is the New Black,” following the success of the drama “House of Cards.”
While Netflix may be becoming a powerhouse in original content along the lines of Time Warner’s (NYSE: TWX) HBO, those hits haven’t translated into the huge subscriber growth that some analysts and Netflix itself were projecting. At the same time, Netflix will have to balance rising content costs against the need to generate more revenue and keep margins from falling too far. Will it be able to keep adding subscribers if it has to raise prices?
Shutterfly (NASDAQ: SFLY): Just ask anyone who has posted a “selfie” to Facebook, Twitter or any other social media forum – online photography is hot. So, therefore, is Shutterfly, which enables its users to share photos online and use them to create calendars and personalized photo albums. So far, so good.
But again, this is a crowded space, and a recent short squeeze has helped propel the company’s P/E ratio to an astonishing 97 times its trailing earnings. That’s an awful lot of perfect pictures priced in right there. Memo to investors: You can use the product, but that doesn’t mean you have to fall in love with the stock, too.
Chipotle Mexican Grill (NYSE: CMG): Jeff Gundlach of Doubleline Capital said it best: A gourmet burrito is an oxymoron, as he told his own investors at a luncheon last April. But despite the incredulity on the part of Gundlach and hedge fund manager David Einhorn, the company’s stock is up 42.7 percent over the last year, even as quarterly earnings growth hasn’t topped 10 percent. It’s now trading at 42 times trailing earnings and more than 30 times prospective earnings.
By any standards, that’s a rich valuation, but especially so when you consider just how fickle consumers can be, and how intense the competition is for their food dollar. (One recent study showed that food trucks are eating into the market share of companies like Chipotle Mexican in many urban areas.)
Deckers Outdoor (NASDAQ: DECK): Even if you don’t happen to believe that this particular fashion trend is getting stale, the stock price remains remarkably high for a company that has reported big declines in sales, margins and net income. Deckers isn’t as pricey as some of the other names here, at least: Its P/E ratio today is just below 19, down considerably from its recent highs of 30, although still above the market average. Moreover, the company appears to be managing its business in such a way as to ensure the fundamentals deteriorate still further, stocking up on inventory and expanding the number of retail outlets even as demand falters.
It’s possible that the valuations for any or all of these stocks will get richer still. But in every one of these examples – and many more that we don’t have time or space to review – the hunger for a great, sexy story about the company’s business model or product has caused investors to temporarily take leave of their common sense.
At the very least, overpaying for one of these stocks means you’re likely to have a more volatile ride going forward: The richer a stock’s valuation, the more likely the market will react violently to any disappointment. At worst, familiarity will cause the sex appeal to fizzle, and leave you gnashing your teeth at the lost opportunities to snap up a real bargain elsewhere.