The stock markets are tools of valuation, offering companies and their creators a mechanism to realise financial gains and to access capital. Markets can offer management the capital necessary to see strategies through and grow beyond the limitations of a private existence. The markets also allow outside investors to participate in the success of a great company and/or management and reap the benefits of a careful analysis and well formed investment thesis.
This is at least the premise on which markets function most effectively and this is generally the case over appropriately long periods of time when the powers of history and actual performance overwhelm the exuberance of momentum and flawed and/or exaggerated assumptions. Each positive period of market performance brings with it a new group of momentum favourites that get carried to great heights well beyond the true inherent value of a company’s prospects. This is both the result of the generally positive outlook of most market participants and these same participants very narrow breadth when considering viable alternatives in their stock selection process. It is a simple case of too much money
As many of these momentum companies inevitably disappoint the eternal optimists and fall back
to more earthly and properly historically-justified valuations, I hope you have participated and duly wrung the register. If you have not yet, here is a list of investments that have exhibited tremendous performance in 2010 but may not carry the yuletide cheer into the New Year.
The Semiconductor Sector
With every significant new technology product introduction, there comes a new rally in semiconductors. Witnessed initially and most profoundly with the introduction and proliferation of the personal computer, reinvigorated by the internet and networks, and then again less significantly following minor introductions like flat panels and MP3 players. Each time these rallies are wrongly labelled long-term secular trends when truly these are temporary demand imbalances in a cyclical industry. This dynamic often provides tremendous shorting opportunities like Sigma Designs (SIGM) and STEC (STEC) or Trident Microsystems (TRID), which I highlighted back in my Street.com days:
Trident Microsystems (TRID) is a classic short play on a hot consumer electronic product cycle. It makes integrated circuits for flat-panel digital TVs, which have captured our imaginations — they’re cool….The great thing about growth investors and analysts is that until proven otherwise, they tend to extrapolate growth linearly and infinitely. This rarely comes true, and it’s unlikely here.
At the time in April 2006 TRID was trading near $30/share, it currently trades for less than $2/share. This is not a unique occurrence check Zoran (ZRAN), Genesis Micro (GNSS), Pixelworks (PXLW), and even bigger names like NVIDIA (NVDA) and Sandisk (SNDK) for further examples. Luckily for SNDK investors they are being given a second (or third) chance to ring the register.
These companies clearly illustrate that specialised electronic component/semiconductor companies are rarely if ever long term growth stories but almost exclusively short term cyclical themes. Even the shares of larger companies like Maxim (MXIM), LSI Logic (LSI) and Micron(MU) have done nothing but go down since the peak in 2001 followed repeatedly by a rebound to lower highs and then another decline.
That is where we find ourselves again today with another rebound in semis on the strength of demand for a new hot product introduction, the smart phone. Again analysts are extrapolating infinite and linear growth and projecting interesting developments like every human carrying a tool belt including at least three cell phones. If these phones are so smart why do we need three of them? Can’t one offer all the functionality of three including multiple numbers and accounts? Is it not the purpose of these devices to incorporate many functions – communications, media, organiser and more – in one device, eliminating the need for multiple devices?
Beyond the generally dismal long term stock performance of companies in the sector, most don’t
consistently make money and revenue growth does not necessarily equal higher profits. When investing, history is your friend and a reference manual for the future and it is not different this time.
So while analysts and pundits are repeating mistakes of seasons past and wrongly predicting strong and continuous growth for the current batch of semi favourites, including Skyworks (SWKS), TriQuint (TQNT)and RF Micro Devices (RFMD), look to the past to recognise the future of these investments is most likely lower than today’s stock levels.
Chipotle Mexican Grill (CMG)
Here is another name I have written about before that the market has driven far too high. This is not
a “lifestyle” stock as some have termed it. Yes, the company uses high quality ingredients, but so do many other restaurants. Healthier eating is a trend that will continue and competition will intensify and it is in no way exclusive to Chipotle. These ingredients can be found in all types of food offerings that aren’t giant burritos also stuffed with cheese and sour cream. In Health Magazine’s ranking of America’s top healthy fast food restaurants Chipotle isn’t in the top 5. Chipotle is a fad like any other and if you believe that, the valuation is downright scary.
There is not one $5 billion or greater market cap restaurant stock trading 4x revs and 50x earnings.
Panera Bread (PNRA), another momentum favourite, trades a paltry 2x revenues and 30x earnings by
comparison and for the “lifestyle” camp is actually ranked #1 on the Health Magazine listing. Chipotle needs everything possible to go more than right for the stock to continue higher. Have a look at other industry comparisons for relative valuation.
This chart shows CMG trades at the extreme high end of valuation relative to its more diversified peers. This makes the company almost impossible to consider as an acquisition candidate. It also makes maintaining these high valuation metrics extremely unlikely historically. The company even indicated with current earning that same store growth would fall to single digits in the coming years. I recommend selling or shorting CMG and moving into a situation where growth prospects are underestimated and valuation too low where acquisition becomes a possibility and a return to market multiple valuations would bring stock appreciation.
Coinstar (CSTR) and Internet Video Distribution
Coinstar, Inc. is a leading provider of automated retail solutions offering convenient services that make life easier for consumers and drive incremental traffic and revenue for retailers. The company’s core automated retail businesses include the well-known Redbox® self-service DVD rental and Coinstar® self-service coin-counting brands. The company has approximately 26,900 DVD kiosks and 19,000 coin-counting kiosks in supermarkets, drug stores, mass merchants, financial institutions, convenience stores,and restaurants.
This company’s stock has recently benefitted from rapid growth at its acquired Redbox DVD kiosk rental service. While the market applauds this short term benefit I am using this opportunity to short the stock. It is not unusual for the market to get caught up in the short-term performance of a company ignoring the ultimate perils of the company’s business strategy. I have shorted many companies while the street applauded short term performance to watch the company actually fail completely or at least the common stock end up significantly lower or worthless.
Several examples include Movie Gallery (MOVI), United Online (UNTD), and Handleman (HDL). These
are all examples of companies that had momentary strong performance but ultimately technology
outmoded these company’s businesses. I believe the same will happen to Coinstar. In the future all
media will be distributed and collected over the internet. CSTR will be left with a massive inventory of unused DVD kiosks to maintain or dispose of. The company claims a digital strategy is in development. That is a crowded space that I doubt will be successful for even the leaders like NFLX. If you don’t own the pipes or the content, the cost structure is not favourable. Throw piracy into the picture and good luck.
As this realisation comes into focus in the coming months and years CSTR stock should work back to pre-Redbox levels in the $20/share area. With significant debt on the balance sheet and the obligation of dealing with 30,000 useless kiosks the ultimate price of the stock may be much lower.
Read more about technology companies with true growth prospects for 2011 and beyond at BulwaTechReport.com.
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