Provides Lesson on Dangers of Shorting High-Octane Momentum Stocks

By Michael Comeau  MAY 20, 2011 9:15 AM

Hot momentum stocks are built upon two things: hype and earnings momentum. As long as those two remain in play, stocks will go up -- crazy valuation be damned. (CRM) once again proved its mettle as king of the software-as-a-service hill, delivering a positively smashing first-quarter earnings report after the close Thursday.

But much more importantly, the market’s jubilant reaction to the numbers gave investors a serious lesson in the dangers of shorting red-hot momentum stocks based upon arbitrary valuation measures.

Let’s jump into the details:

Sales rose 34% year-over-to year to $505 million, comfortably beating the consensus forecast of $482 million.

Non-GAAP earnings came in at 28 cents a share, beating Wall Street’s expectations by one penny.

3. The company’s second-quarter guidance calls for earnings of 29 to 30 cents a share on revenue of $526 to $528 million, numbers which are well above Wall Street’s current forecast.

4. The company guided for full-year revenues in the $2.15 to $2.17 billion range, which is about 2% above consensus. Full-year non-GAAP EPS guidance is now $1.30 to $1.32 a share, nicely ahead of the $1.27 for which analysts are looking.

5. Salesforce added 5,400 net paying customers, bringing the total to 97,700.

Shares of Salesforce popped as high as $146.99 after-hours before settling at $145.87, a gain of 7.4% from the close.

High P/E Ratios Can Go Higher

The vast majority of bear cases regarding revolve around the stock’s valuation.

I’m not going to call anyone out by name. Fire up a Google search and you’ll find the haters on this stock in a jiffy.

We can all agree that Salesforce is trading at a nauseating valuation. At Thursday’s close, the stock was trading at 107 times expected full-year non-GAAP earnings. Yes, 107 -- that's not a typo.

But wait! If you take that $145.87 settling price and divide it by $1.31 a share (the mid-point of full-year guidance), that P/E expands to 111!

So what’s the lesson?

Do not short momentum stocks based upon valuation!

Hot momentum stocks are built upon two things: 1) hype, and 2) earnings momentum. As long as those two elements remain in play, the stocks will still go up -- crazy valuation be damned.

To illustrate the danger of a valuation-based short case for Salesforce, let’s create a hypothetical scenario for its Q2 earnings report. Assume the company delivers another bang-up quarter, and takes full-year EPS guidance up to $1.40 a share.

What would happen? Well, investors would start valuing the stock on a higher earnings base, and possibly an even higher earnings multiple.

That means a higher stock price.

Six months from now, Salesforce could easily be over $200 if the earnings beats keep on coming, especially since investors will start to look at the following year’s numbers.

So what’s 111 times the as-of-yesterday fiscal 2013 estimate of $1.84? $204.

And what if that multiple goes to 120? And that estimate goes to $2? You have a stock trading at $240 -- 77% above yesterday’s close.

I’m not saying that the stock is going to $240. I’m just here to point out that it could.

If you want to bet against the stock, do it based upon some expected disruption of the company’s earnings-driven hype, not because you think the stock is "expensive" based upon some arbitrary valuation measure.

Sometimes expensive stocks just get more expensive and cheap stocks get cheaper.

Just look back at 2007 and early 2008 when housing was getting ready to collapse. Banking and housing stocks were trading at single-digital P/Es. Investors still got creamed on stocks like Citigroup (C) and DR Horton (DHI).

And if a stock can trade at 111 times earnings, why can’t it trade at 120 or 130 times earnings?

Tech-Related Housekeeping Notes

1. LinkedIn (LNKD): Overpriced?

LinkedIn came public Thursday at a $4.25 billion valuation, and the Negative Nancys are out in force declaring it overpriced. This sounds exactly like the crowd that hated the Google (GOOG) IPO back in 2004, so take the negative commentary with a grain of salt.

My take is this: Folks are going gaga over LinkedIn because it’s the closest thing to Facebook on the market right now. I would wait until they report a quarter before going long or short.

2. Amazon (AMZN) Says Kindle eBooks Outselling Physical Books

Apple’s (AAPL) iTunes and App stores are the best online-retail outlets because they keep people on a platform for which they’ll regularly buy new hardware.

Well, let’s put Amazon’s ebook operation in the same category, because it’s keeping people in the Kindle hardware + content ecosystem. It also happens to be the perfect hedge against the eventual decline of the physical book -- the product upon which Amazon’s business was originally based.

Well played, Mr. Bezos!

Position in AAPL

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