4 Prime Stocks That Are Losing Their Power
When stocks or other assets rise in value, investors become enthusiastic about their future prospects. Furthermore, the rising stock price serves to validate this conviction — the gambler whose activity is rewarded becomes convinced that his or her actions are rational in nature. However, fundamentally, this makes no sense — a rising asset price means that there is less validity to the bullish case, and vice versa.
So it shouldn’t surprise anybody that several of the stocks that led the market higher in the past couple of years are lagging significantly in 2014. We find that many stocks reached absurd valuations, and again, investors rationalized these valuations because the market was rewarding them. After all, if a stock trades at 100 times earnings, you would feel pretty smart having purchased it at 70 times earnings even if it is only worth 15 times earnings.
If we look at the bifurcated market of 2014, we find that prudence and fundamental analysis seem to be paying off; those who avoided, or better yet, those who shorted the stocks I am about to mention saw right through the momentum and rightfully arrived at the conclusion that they simply had to come down. Not only are these stocks down for the year, but I think they have further to go. Let us see why.
Amazon (NASDAQ:AMZN) is a business that touches nearly all of our lives — it is a convenient online platform for purchasing just about everything. Given the company’s competitive advantage, investors were convinced that it didn’t matter that Amazon wasn’t generating any profits or paying any dividends. Everything was going back into the business, and investors were just fine with that.
But lately, this hasn’t been fine. The story today is basically the same as it was at the beginning of the year — the company is growing revenues, and it is the leader in online commerce. But shares are down 27 percent versus the S&P 500, which is up about 2 percent. I think a lot of holders of Amazon shares are coming to the realization that it is better to put your money in a boring, stable, and profitable business such as Exxon Mobil (NYSE:XOM) — which is hitting all time highs — than a high flier that might, some day in the future, report a profit.
2. Whole Foods Market
Whole Foods (NYSE:WFM) is down 33 percent for the year, and it was down 19 percent alone on Wednesday. The company had been growing earnings comfortably as people love shopping at a grocery store that specializes on wholesome, organic, GMO-free vegetables and fruits, as well as free range grass-fed animals.
But this year, investors realized that rising sales and rapid expansion are no substitute for profit growth, and when a stock trades at 40-times earnings — as Whole Foods did in January — it needs to grow its profits. In the last two quarterly reports, the company reported sales growth, but profit growth declined in Q4, and it went to 0 percent in Q1. The reasons for this are fairly obvious. First, food prices have been rising, and that hits Whole Foods’ margins. Second, the grocery business is incredibly competitive. Tons of stores sell groceries, and there are several grocery store chains which all have razor thin margins. Third, consumers are cutting back, and that means that high-priced Whole Foods’ items are out. The stock still trades at 25 times earnings, but the growth seems to be gone for now. This can be a recipe for disaster, and I expect Whole Foods shares to trade lower.
3. Chipotle Mexican Grill
Chipotle (NYSE:CMG) has outperformed the first two companies I list here. It is only down 6 percent for the year. But that’s still pretty bad considering the 2 percent gain we have seen in the S&P 500. Chipotle is in a similar boat as Whole Foods. The company has continued to show strong sales growth, but its profit growth has diminished. Furthermore, the reasons for this are the same. First, food price are rising, and this is eating into the company’s margins. Second, the restaurant industry is extremely competitive, and this makes it very difficult for companies to raise its prices without some sort of blowback. Third, consumers are cutting back, and Chipotle sells a relatively discretionary item. Consumers would rather save money and go to the grocery store. They are also less likely to pay the premium for guacamole. With the stock still trading at over 40 times earnings, I expect that we will see continued weakness, and investors should continue to stay away.
Netflix (NASDAQ:NFLX) has actually avoided the problems we have seen with the first three companies. It is growing its sales and its profits. It is also growing its profit margins. Its business is growing steadily, and it is one of the leaders in the internet media space. Furthermore, it is in a business that has a fairly high barrier to entry. Of the four businesses I list here, this one is probably the best investment.
Regardless, the stock is down 13 percent for the year. Why? The stock is simply too expensive. Currently shares trade at 120 times trailing earnings, and it trades at 80 times 2014 estimates. This is simply too high, but investors were willing to pay it because they were assuming that the company’s past stellar earnings growth is sustainable well into the future. I suspect that the company can grow its earnings at a fast pace, but as is the case with most growth businesses, this growth ultimately slows over time. This needs to be priced into the company’s stock, and it isn’t. Therefore, shares are coming down, and I suspect that this will continue.
Staying on the subject of Netflix, the online streaming company is currently part of an angry group of the country’s most powerful tech companies. In an earlier article, we described how Microsoft, Amazon, and Netflix had penned a letter to the Federal Communications Commission, asking the organization to throw out a new draft of net neutrality rules that would allow for Internet service providers to charge content providers for the amount of bandwidth their content takes up.
Here’s a recap of that story:
The tech companies and consumer advocates believe that this will end the Web’s productive period of innovation, as smaller startups won’t be able to afford to pay for bandwidth and the Internet will become dominated only by established companies. Internet service providers, of course, are looking forward to a new revenue source. Comcast (NASDAQ:CMCSA), for example, has already forced Netflix to pay for faster streaming speeds for its customers.
The letter, dated May 7, has the tech companies claiming that a threat to net neutrality is a threat to America’s dominance of the technology industry as a whole. “The Commission’s long-standing commitment and actions undertaken to protect the open Internet are a central reason why the Internet remains an engine of entrepreneurship and economic growth,” the companies wrote. “According to recent news reports, the Commission intends to propose rules that would enable phone and cable Internet service providers to discriminate both technically and financially against Internet companies and to impose new tolls on them. If these reports are correct, this represents a grave threat to the Internet.”
FCC Commissioner Mignon Clyburn responded to the letter and other complaints in a blog post, saying that more than 100,000 people have reached out to the FCC, asking the agency to do whatever it can to reinstate net neutrality and keep the Internet an open space for everyone. Clyburn said that she sees the D.C. circuit court’s decision to overturn the commission’s net neutrality laws in January “as a unique opportunity for us to take a fresh look and evaluate our policy in light of the many developments that have occurred over the last four years.”
She added: “There is no doubt that preserving and maintaining a free and open Internet is fundamental to the core values of our democratic society, and I have an unwavering commitment to its independence.”
At the end of last month, reports started coming out that the FCC was caving on the issue of net neutrality and that the new draft of the laws basically undermined everything that the organization and the idea of an open Internet stood for. Reportedly, the FCC’s new draft will allow content providers to buy faster Internet speeds if such deals are made on “commercially reasonable” terms. Such terms would be determined by the FCC on a case-by-case basis. This is an attempt to make a version of net neutrality that will keep an open Internet monitored by the FCC while allowing companies to adapt to a changing marketplace, which has seen Internet traffic skyrocket.
Companies and consumer advocacy groups spoke out against the rumored changes, prompting FCC Chairman Tom Wheeler to fire back against the criticism in a statement to The New York Times, saying: “There is no ‘turnaround in policy.’ The same rules will apply to all Internet content. As with the original open Internet rules, and consistent with the court’s decision, behavior that harms consumers or competition will not be permitted.”
Given that an appeals court in Washington, D.C., ruled that the FCC was overstepping its bounds by trying to bar Internet providers from blocking certain kinds of online content or charging the companies that take up the most bandwidth a higher fee at the beginning of the year, it’s uncertain what the organization can do to keep an open Internet if the rules don’t stand up in court. The commission is set to vote on the proposed changes, which have not yet been made public, on May 15.
Disclosure: Ben Kramer-Miller has no position in Netflix, Chipotle, Whole Foods, or Amazon.