Have Stocks Become ‘Absurd’?

Source: Thinkstock

Source: Thinkstock

Recently, the famous short seller Bill Fleckenstein told CNBC that he is raising money in order to set up a fund that will sell technology stocks short. He also said that stock valuations in many cases are absurd. Investors are justifying paying historically high prices for stocks because the Federal Reserve’s benchmark interest rate is near 0 percent. This makes it extremely difficult to earn returns and an investor might justify holding shares of, for instance, Facebook (NASDAQ:FB) — which trades at nearly 50 times 2014 earnings estimates — than holding cash.

Now that isn’t to say that there aren’t pockets of value in the stock market. For instance, a couple of companies that I like – CF Industries (NYSE:CF) and Kinross Gold (NYSE:KGC) — trade at about 10 times earnings and at 8 times earnings, respectively.

But Fleckenstein is absolutely correct in his assertion that valuations in some technology companies are reaching absurdity. I have already pointed out regarding Facebook. We can also look at some of the 3D printing companies. While there is a lot to like about this industry going forward, some of the valuations have become ridiculous. For instance, this piece, published by Bloomberg in January about Fleckenstein’s intention to go short, highlights Voxeljet AG (NYSE:VJET), which is a 3D printing company that earned just $290,000 in the third-quarter of 2013 but which had a $593 million market capitalization at the time (the company now has a valuation just under $400 million.)

With this in mind, it is evident that there are a lot of pitfalls in the stock market. While short selling should be left to the professionals, retail investors can do the following in order to preserve their capital and make money in the stock market longer term.

First, avoid “hot stocks,” especially if they don’t have the earnings or the sales to back up their valuations. When you buy these stocks, you are betting on a story. Voxeljet AG investors may turn out to be correct, but it is very difficult to know this without having intimate knowledge of the company’s patents and products. Most retail investors don’t have the expertise to make such judgments, and they should stay away from these sorts of investments.

Second, focus on valuations when making investment decisions. If you find stocks that trade with low P/E ratios, that pay dividends, and that buy back their own shares, you at least have a quantitative basis on which you are justifying your investments. For instance, if you buy stock in Exxon Mobil (NYSE:XOM), you know that the company is going to earn about $1 for every $13 you invest. You know that they will pay you a dividend of 2.6 percent, and you know that they will be buying back their shares. It may not be exciting, but it is simple and profitable.

Third, invest in companies you understand, or as Warren Buffet says, stay within your circle of competence. Chances are unless you’re an industry expert you don’t know the specific benefits of a Voxeljet AG 3D printer. You also don’t know about that company’s patents. Therefore, it doesn’t make a lot of sense to invest in this company’s stock, especially since it has limited revenues and virtually no profits relative to its valuation.

On the other hand, you probably have a fair amount of knowledge of, for example, Visa’s (NYSE:V) product. While you may not know the details, there’s a decent chance that you use a Visa card regularly, and you know that Visa makes money every time you use it. While Visa trades at a somewhat elevated valuation at 24 times 2014 earnings estimates, the company has a clear source of revenue, and it has a product that you can relate to. Therefore, while it is within the realm of possibility that Voxeljet AG will turn out to be the superior investment, from the perspective of most people reading this article an investment in Visa makes much more sense.

Ultimately, there are a lot of complex stock investments out there. Many of them have appeal only insofar as they are marketed to investors who want to profit from the next big thing. But if you look at these investments from a quantitative perspective, they really make no sense. Such investments become more ubiquitous in a market environment in which stocks are hitting all time highs. This is why Fleckenstein is planning on starting a technology short selling fund. Chances are pretty good that he is not going to be shorting stocks like Microsoft (NASDAQ:MSFT), which trades at 15 times earnings and pays a 2.7 percent dividend. He is going to target names such as Voxeljet AG and other companies that are difficult to understand and that don’t generate enough profits to justify their lofty valuations. You don’t need to be an expert like Bill Fleckenstein in order to realize that these stocks are not worthwhile investments. You just need to have a common sense approach to investing.

Disclosure: Ben Kramer-Miller is long Exxon Mobile, Visa, Kinross Gold, and CF Industries.

More From Wall St. Cheat Sheet: