Too often near market tops investors lose sight of reality and reason. They begin to make investments based on faith and unrealistic expectations. As a result, we can see stocks soar to unimaginable valuations that seemingly make no sense despite the fact that analysts, who are paid to provide a reasoned assessment of a stock, jump on the bandwagon — probably because they are afraid of saying “enough is enough” and having the stock soar another 50 percent.
As an investor, you should be able to spot these stocks. Before I list examples, there are a few things that bulls always resort to arguing which seem silly if you aren’t caught up in the hype. For instance, they will say that “earnings and cash-flow doesn’t matter; look at “clicks” or “users” or earnings potential in a hypothetical situation.” If you see a situation like this and the stock trades at an irrational valuation (say, 35 times earnings or higher), then be very careful. Of course, not all of these situations are bubbles — just look at Google 8 years ago. But most of them are, and if you aren’t careful you can easily lose 80 percent of your investment or more.
Consider these examples as illustrative of this irrational euphoria.
1. Amazon (NASDAQ:AMZN)
I have seen more excuses justifying Amazon’s valuation than any other stock. Investors who are bullish explain away the company’s lack of profitability by claiming that the company is spending all of its money developing its infrastructure and building its business. It has even been referred to as a “start-up.” The fact of the matter is that Amazon has a lot of issues aside from the obvious fact that it cannot make money.
The first is that Amazon is entering all sorts of markets and trying to compete in them. It has issued a phone, a streaming platform, a payments system, a collectibles trading platform, and numerous other products. It would be better off focusing its efforts on one or two of these things and doing them very well. Instead, its streaming business is losing out to Netflix (NASDAQ:NFLX) and its phone is a dud.
Second, investors assume that the company will at some point be able to stop spending so much money on infrastructure and generate profits. There are a couple issues here. The first is that analysts have been promising this for years and it hasn’t happened. The second is that the company is at risk of losing its strong market position should it stop investing so heavily. Since it is investing in so many markets, it needs to keep investing to put the pressure on all of its competitors, and so it is difficult to see the point at which Amazon will be able to make the switch from a growing “start-up” to a cash-flow generating investment.
Given these points, I think Amazon is mostly hype at the current valuation, and it is at risk of falling substantially lower even though it has already lost nearly 25 percent of its value for the year.
2. Chipotle Mexican Grill (NYSE:CMG)
Chipotle has continued to rise despite the fact that I have publicly made bearish statements. But I’m sticking to my guns: this stock is grossly overvalued at 50 times earnings. However, investors are convinced that Chipotle is the next McDonalds (NYSE:MCD). It makes food that people like and it makes it quickly. Furthermore, it is growing its business rapidly.
Bulls have claimed that the company is going to be able to grow its business at 25 percent per year or faster despite the fact that we have seen signs that the company is stumbling when in the first-quarter it saw its margins compress due to high food prices. In the second-quarter, it resorted to raising its prices and the company posted a strong quarter. But as strong as it was, the company simply isn’t growing quickly enough to justify a 50 price to earnings multiple.
Investors need to realize that there are two risks to the company’s long-term growth. The first is that the fast food industry is cutthroat. At any time a new competitor can come along and steal Chipotle’s thunder. If this happens, the stock could easily trade in-line with the rest of the restaurant sector, which is around 20 times earnings or 60 percent lower. My second concern is that the law of large numbers prevents Chipotle from continuing to grow as quickly as it had in the past as it becomes larger. Eventually, Chipotle will saturate the market, and when this happens growth will slow and the company’s multiple will compress.
While the shares may continue to rise due to momentum and euphoria, this is a story that will not end well, and I think investors should sell now.
Disclosure: Ben Kramer-Miller has no position in any of the stocks mentioned in this article.