One warning signal that only reckless investors disregard is extreme overvaluation.
And one compelling sign of extreme overvaluation is a stock selling for 100 times revenue.
Some stocks with that sort of wild price tag do go up, but that is the exception. Losses are common. Gigantic losses are frequent.
That’s why I periodically warn about stocks selling for 100 times revenue or more. Stocks on my warning list a year ago fell 38.5 percent from Feb. 14, 2012, through Feb. 14, 2013, while the S&P 500 returned 15.3 percent. Both figures include reinvested dividends.
Four of the five stocks on last year’s list fell. The biggest disaster was Houston American Energy Corp., which dropped 98 percent after major problems with a well.
Pendrell Corp., an intellectual-property consultant, fell 51 percent. Its predecessor, ICO Global Communications Ltd., lost a court battle in which it claimed that Boeing Co. breached a contract to help ICO create a satellite network.
Star Scientific Inc., a maker of antismoking products and nutritional supplements, declined almost 50 percent. One problem: The company settled a lawsuit against Reynolds American Inc. for $5 million — a tiny fraction of the proceeds it had led investors to expect.
Ziopharm Oncology Inc. fell 9 percent.
The sole gainer in the group was Lexicon Pharmaceuticals Inc., up 16 percent.
Last year’s results were no fluke. I have compiled eight such lists. The first seven were published in 2000 through 2006. The last one was a year ago. Six of the eight lists showed losses. Seven of the eight performed worse than the S&P 500. The average return overall was a loss of 32 percent For the same eight 12-month periods, the average return for the S&P 500 was positive 5.9 percent.
There’s logic behind this. Today, the average stock sells for about 1.4 times revenue. When shares go for 100 times revenue it means investors are building castles in the sky.
Bear in mind that stocks advance by exceeding expectations. So it would take success even better than the majority is expecting to move the stock higher. At the moment, only about 0.4 percent of US stocks sell for 100 times revenue or more.
Here are five stocks that currently meet the deadly description:
Ariad Pharmaceuticals Inc. focuses on cancer treatment, with emphasis on cancers that are drug resistant or hard to treat. One of its drugs, Iclusig, for leukemia, was recently approved. Ariad had only about $1 million in revenue for 2012, but analysts anticipate $43 million in 2013. The price-to-revenue ratio is 5,700 based on revenue already achieved. Based on projected 2013 revenue it is about 84.Of 21 analysts covering the stock, 18 recommend it. I am skeptical the stock can grow into its valuation in a reasonable time.
Two stocks are back from last year’s list. Ziopharm Oncology sells for 437 times recent revenue. It, too, is a cancer specialist. Lexicon Pharmaceuticals, the only stock on last year’s list that rose, now sells for 717 times revenue. The company is working on drugs for a wide variety of diseases.
Lexicon’s revenue was about $1 million last year and is expected to hit $16 million this year. The market value of the stock is over $1 billion.
Achillion Pharmaceuticals Inc. is working on drugs for AIDS, hepatitis, and other conditions. It is less pricey than the preceding three, but still sells for 270 times recent revenue.
The one non-biotech company on my list this year is Virnetx Holding Corp., which specializes in secure Internet communications. Revenue was $2.4 million last year and is expected to be $18 million this year. The market value is $1.79 billion.
Excuse me, but I think Virnetx’s niche is likely to attract a lot of competition, and high-quality competition at that.
John Dorfman is chairman
of Thunderstorm Capital in Boston. His firm or clients may own or trade securities discussed in this column.