As earnings season gets underway, investors have been delivered a huge jolt in one of their favorite stocks. It shouldn’t be a huge surprise, considering this stock was one of the most expensive stocks in the S&P 500. But it’s a wake-up call for any other pricey stocks. If you own one of them, be sure you are not getting in front of a train wreck.
The stock in question: Intuitive Surgical, Inc. (NASDAQ:ISRG), which traded at around $580 in February. Thanks to a stunning one-day plunge, shares are suddenly flirting with the $400 mark. Tepid quarterly sales get the blame, though the size of this stock’s drop is surely due to the stock’s valuation.
Back in February, when this stock was making fresh highs, it was valued at more than 30 times projected 2013 profits. Considering that profits were on course to grow around 15% (from 2013 to 2014), that was an unconscionably high earnings multiple.
After conceding that second-quarter sales would likely trail estimates by $50 million, analysts have been busy ratcheting down future growth assumptions. A major concern: Sales grew 23.5% in the first quarter (on a year-over-year basis) but just 7% in the second quarter.
The ever-tougher spending environment in health care is a key factor (and something you should consider if you own other companies that make medical devices), and even after the huge plunge, investors need to tread lightly with this falling star.
Beyond the quarterly shortfall, analysts at JMP Securities noted that “the reasons cited (conservatism on the part of insurers/physicians and a tougher capital sales market) introduce longer term, more unpredictable concerns.” That’s not a healthy backdrop for any stock with a high price-to-earnings (P/E) ratio.
A Compounded Problem
As the Intuitive Surgical, Inc. (NASDAQ:ISRG) situation reveals, high P/E stocks are vulnerable on two fronts.
If earnings estimates are lowered, then the ideal P/E for those lowered profits should also be lower. For example, a company that is boosting profits at a 30% pace and trades at 30 times its $3 a share earnings forecast would be worth $90. But if analysts lower their profit growth rate assumptions (and hence target earnings multiple) to 25 after a company lowers its earnings per share (EPS) guidance to $2.50, then shares would fall from $90 to $62.50 (2.50 x 25).
Across the S&P 400 and S&P 500, there are 93 companies that trade for more than 30 times projected 2013 profits. As we head into earnings season, these are precisely the companies that will be under the gun to deliver robust results and forward outlooks.
Here’s a quick view of 15 pricey stocks.
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Risks to Consider: As an upside risk, pricey stocks are often heavily shorted, and further advances in this bull market could lead to short covering, which could push these stocks even higher.
Action to Take –> These companies are not only subject to so-called execution risk (that is, they must deliver on the high expectations in place for them), but they are also subject to market risk. If the market starts to head south, then these are precisely the kinds of stocks for which investors will “shoot first and ask questions later.” That’s why it pays to stick with stocks that represent solid values or dividend yields. They are far more likely to hold their own if the market weakens.
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