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Momentum stocks lend false sense of security

Tuesday, July 22nd, 2014

Last week, the Dow Jones saw another new high. While some companies are very pricey, there is data showing there is more left in upside potential to come. Investors need to be careful what they buy.

Today I’m going to break down the fundamentals of Lumber Liquidators, which was a momentum stock that has been cut in half. I’m doing this as a warning to investors to be careful of owning momentum stocks.

First, I want to give you some data showing that overall, good companies still have more increases to come. Prices for initial public offerings for the second quarter of 2014 were the highest since the tech bubble in 2000.

Eighty-three IPOs were priced in the second quarter of 2014; that is a 36 percent increase over the second quarter of 2013. These initial public offerings generated $21 billion in proceeds just in the United States. Global deals of initial public offerings were $56 billion from 127 deals.

With the high level of initial public offerings, this shows confidence in the equity markets from business leaders.

I always try to warn investors about momentum stocks. Momentum stocks are emotionally driven and it feels good as the stock continues to climb and the holders continue to believe it will go on forever. The problem is they do not look at valuations and come up with other reasons that the stock will continue to do well.

This false sense of security can go on for months, sometimes even years. However, sooner or later, the bottom will fall out and the stock holders will be devastated by the losses. Instead of taking responsibility for not understanding the valuations of the company, they blame the stock market as a risky place to put one’s money.

So, in hopes of helping you, I’m going to review the fundamentals of Lumber Liquidators. And one other thing: Please don’t believe that you have magic powers that will let you know when to get out of those momentum stocks.

Lumber Liquidators Holdings Inc. (NYSE: LL) has a market cap of $1.5 billion. The stock has a 52-week high of $119.98, which was hit in November 2013. Since then, the stock has been on a major decline with a reversal or two along the way. However, the 52-week low stands at $53.27, which was reached just recently.

The company has 309 stores in the United States and specializes in hardwood flooring. I believe the stock went to $119.98 due to the expectation that housing was doing well. While this is true, the valuations on this stock got way too high.

The price to earnings ratio over the last 12 months trades at 20 times earnings, slightly higher than the industry average of 19.8.

Even with the current pullback of more than 50 percent, the stock price is still high at 1.5 times sales when compared with the industry average of 1.2.

One valuation in favor of Lumber Liquidators is price to tangible book value of 4.9, which is under the industry average of 7.0. Price to cash flow, however, goes back to favoring the industry average at 13.6, which is well below the company price to cash flow of 16.8.

Lumber Liquidators has done a good job of grinding sales higher year over year. The last 12 months were at a rate of 18.7 percent -- just over three times the industry at 5.3 percent. Earnings per share year over year for the last 12 months look very good with a 37 percent gain, which is above the industry average of 25.9 percent gain.

It should be noted that earnings per share quarter over quarter fell by 13.4 percent when the industry climbed by 20.5 percent. This decline was a surprise in earnings and this is when the stock fell 50 percent.

The balance sheet of Lumber Liquidators is strong with a current ratio of 3.2 -- not quite three times the industry average of 1.2. This company is in the industry of home improvement retail and I was surprised to see that the industry average has a debt to equity of 103 percent.

A positive for this company is its debt to equity, which is zero. This means the company has no debt on the balance sheet and owes money to no one. Another positive for the company is the return on equity of 26.7 percent the last 12 months, which is less than the industry average of 30.4 percent, but a company with a return on equity of more than 15 percent is doing well. The net profit margin for Lumber Liquidators is also good at 7.4 percent, which beats the industry average of 5.9 percent.

There could be a problem with the inventory of this company; the inventory turnover of the last 12 months was only 2.6 times, which was well below the industry average of 4.1.

Any retailer with a low inventory turnover rate needs to clear out that inventory and generally has to reduce prices, which will hurt profit margins.

And as we see here, Lumber Liquidators saw its earnings per share quarter over quarter decline while sales were up. This could be due to declining profit margins in the company trying to move inventory.

Looking at the average earnings per share going out to December 2015, I see the company is expected to earn $3.37 per share. The good news is that it is up from $2.74 for the year ending December 2014. The bad news is I use the 40-year average of the forward PE of 16.5 that would give a target sell price of $55.61, which is currently where the stock stands.

Looking back 90 days for the year ending December 2015, the earnings-per-share estimate was $4.39 at this time the stock had begun its decline and was trading about $90 per share and with earnings-per-share estimates of $4.39. The forward PE at that time was 20.5 -- in my opinion, well into the high-risk category.

So I would recommend that for any companies you hold in your portfolio, be sure to check all the fundamentals of your companies regularly to verify that the forward PE is not trading above 16.5.

Do you have a question or a company you would like us to take a look at?
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