How To Profit From These 3 Overvalued Sectors

Adam Fischbaum's picture

Friday, January 23, 2015 - 1:30pm

by Adam Fischbaum

 

Flea markets crack me up. 

 

Most of the vendors seem like they cleaned the junk from their garage and assigned an arbitrary, often overvalued, price to it.

 

There are times when financial markets resemble a flea market. And lately that's exactly how it seems.

 

 

The U.S stock market has been on a tear over the last five years.

 

Since the market bottom during the 2008 financial crisis, the S&P 500 has turned in an average annual total return of close to 15%. Not bad for a market everyone thought was going out of business.

 

But as we've discovered, trees never grow to the sky. If you're familiar with my work, you'd know that paying close attention to valuations is a core tenet of my investment philosophy.

 

I wrote about my concerns with broader market valuations recently. This week, I want to drill down to valuations in a few specific sectors and stocks.

 

 

Utilities
2014 was a banner year for utility stocks. Fear of volatility and attractive yields pushed the Dow Jones Utility Index up 28% for the year, trumping the S&P 500's 11% gain.

 

Traditionally, nervous investors scoop up electric utility stocks in uncertain markets. You see, these stocks are typically recession proof, because electricity is a necessity. This ensures stable cash flows that reliably support dividend payouts. This especially useful in a low interest rate environment.

 

According to a recent report published by Credit Suisse, 45 widely-held regulated electric utility stocks are trading at the highest forward price-to-earnings ratios seen in the past 10 years. Average industry multiples are approaching 18, while the historical norm is around 13.

 

Let's look at one of Warren Buffett's favorite utility holdings, American Electric Power Co., Inc. (NYSE: AEP), which absolutely crushed it last year.

 

 

 

The rise in price shrank the stock's dividend yield to 3.3%, and the stock carries a lofty forward P/E ratio of 17.

 

Such valuations are usually seen in high-growth sectors, and the regulated electric utilities sector isn't characterized by high growth. This means the share price expansion isn't being driven by higher earnings. It's being driven by emotions, which can turn on a dime.

 

A stock with a forward P/E that trades at nearly a 40% premium to its sector's historical average should be considered overvalued. A 3.4% yield is just not enough compensation for that kind of risk.

 

Biotechnology Sector
After a rough first half of 2014, the biotech sector roared back to life posting stellar returns for the year.

 

 

The SPDR S&P Biotech Index ETF (NYSE: XBI) really shot the lights out, growing by more than 30% in 2014. However, it wasn't without fair amount of volatility. This can be explained by dissecting the nature of the biotech sector.

 

Many of these companies, ranging from small to mid-size market capitalizations, are on the cutting edge of medical science, developing state-of-the-art drugs for chronic diseases such as cancer and diabetes. Often, they're financially partnered with the likes of the mega-cap, mainstream pharmaceutical companies like Pfizer, Inc. (NYSE: PFE) and Sanofi (NYSE: SNY).

 

In essence, the larger companies are using these small, high-tech pharmaceutical outfits as their research labs or, "pipelines" as they are referred to in the industry. Some "big pharma" companies rationalize that it's cheaper to buy a pipeline than to actually invest in their own.

 

However, regardless of strength these biotech's partnerships and products, most of are unprofitable -- often far from it. Historically, these firms operate without any earnings per share (i.e. a loss).

The stocks trade mostly on speculation of the results of experimental drug trials. If clinical trials are successful and the medication is approved by the FDA, then share prices can spike. If not, then shares can take a huge hit.

 

One specific and high-profile example is biotech wunderkind Isis Pharmaceuticals, Inc. (Nasdaq: ISIS).

 

 

After the biotech crash of mid-2014, shares of Isis have more than doubled thanks in part to the company's strong suite of effective RNA-based autoimmune therapies, multi-billion dollar partnerships with Glaxo Smith Kline Plc (NYSE: GSK) and Astra Zeneca Plc (NYSE: AZN) and semi-regular touting from CNBC talking head Jim Cramer.

 

But aside from the hype and improving cash flows, the company is still unprofitable. Isis finished 2013 with a net loss of $0.55 a share, according to Firstcall Research. Analysts expect the company to report a loss of $0.63 a share for 2014 and a $1.08 loss is forecasted for 2015.

 

Top officers at the company, the Chairman and COO in particular, sold more than 42,000 shares in early January 2015. Mighty convenient to sell at the top.

 

This stock looks overdone and aside from the hype, the fundamentals and the charts suggest downside ahead. As I've said many times before, I'm no wiggle reader, but the chart tells me this stock will roll over soon. On a one year basis, the first shoulder of a classic "head and shoulders" formation is falling into place. Longer term charts show the current movement to be a second shoulder.

 

Technology Sector
As usual, technology was a mixed bag last year.

 

Consistent performers like Intel Corp. (Nasdaq: INTC), Cisco Systems, Inc. (Nasdaq: CSCO) and Microsoft Corp. (Nasdaq: MSFT) delivered one year returns in excess of 20% without stretching their valuations. On average, these three stocks trade with a forward P/E of 15, which implies that they have room to move higher.

 

Too bad hot IPO's like GoPro, Inc. (Nasdaq: GPRO) and yet-to-be public tech entities like Uber or Snapchat with multi-billion dollar valuations overshadowed the solid results from industry leaders.

 

All in all, judging by the performance of the iShares U.S. Technology ETF (NYSE: IYW), 2014 was a decent year for tech in general.

 

 

 

The 18% total return doesn't feel to out of whack. However, at around 23, the P/E ratio is a little rich for my discipline when compared to the S&P 500's 17 P/E. Overall, tech isn't a bad place to be. You just have to be selective.

 

One tech name that I don't see a lot of upside in is Yahoo!, Inc. (Nasdaq: YHOO). The stock did well last year rising over 40%, which has currently pushed the forward P/E close to 30; a 26% premium to the sector and a 100% to Intel, Cisco and Microsoft.

 

But the company also faces massive fundamental issues.

 

What exactly is Yahoo? Identity is the biggest challenge facing the company.

It's not really a search quantity anymore. Google, Inc. (Nasdaq: GOOG) owns that space.

 

So should Yahoo evolve into a content destination? It needs to but that's not happening. AOL, Inc. (NYSE: AOL), Netflix, Inc. (Nasdaq: NFLX), and Amazon.com, Inc. (Nasdaq: AMZN) are diving headfirst into content acquisition and production. AOL's purchase of the Huffington Post and Netflix's Golden Globe for its original series "House of Cards" are hard evidence.

 

Outside of Yahoo Finance (an extremely solid vertical), the company doesn't seem to be making much of an effort. Remember, CEO Marissa Mayer, a Google alumnus, comes from engineering. This company needs a media person quick.

 

 

Clearly, Yahoo's substantial stake in Alibaba (NYSE: BABA) was a shrewd investment. But that seems to be the only thing that propelled the stock last year. Yahoo's lack of longer term vision doesn't warrant the current valuation.

 

Risks To Consider: When talking about avoiding or shorting certain stocks, I am reminded of the famous John Maynard Keynes (a legendary trader in addition to his notoriety as an economist) quote: "The market can stay irrational longer than you can stay solvent." Words to live by. Trading based on a short strategy can be extremely risky. Stocks under the swoon of a popular idea or surfing a momentum wave may still have some juice left in them.

 

Action To Take --> These sectors and representative names have had great runs. Investors holding these stocks with gains should consider stop loss or covered call option strategies in order to protect their profits. Taking them off of the table isn't a bad idea either. Investors considering these names and sectors should probably look elsewhere to commit new money.

 

Want to avoid the hassle of digging into a company's financials and decoding corporate lingo? StreetAuthority's Stock Of The Month delivers full analysis of one premier investment to your inbox each month. To learn more about this service, click here.

 

Adam Fischbaum owns shares of CSCO, GSK,.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.