They are the analysts' favourites – with seemingly never-ending growth in sales and profit. So-called 'market darlings' are the stocks everyone is talking about, and everyone seems to recommend.
Share prices seem to spiral upwards with little attachment to reality, and P/E ratios skyrocket. It might be counter-intuitive, but the time when everything looks perfect is exactly the time to be on your guard.
According to a recent report in the Australian Financial Review, of 52 stocks that were trading on an average P/E of over 16 during the 2007 financial year, only 16 were now trading above their 2007 share price.
APN News & Media (ASX: APN), PaperlinX (ASX: PPX) and TransPacific Industries (ASX: TPI) were amongst the worst hit, falling by more than 50 per cent, with Paperlinx and TransPacific falling by 98 per cent and 92 per cent respectively.
Expectations versus reality
Worleyparsons (ASX: WOR) was another market darling with the company's net profit rising from $8.8m in 2001 to over $390m in 2009. Earnings per share jumped from under 7 cents to over 160 cents. The share price went along for the ride, taking off from under $2 to over $52. At that price the company was trading on a P/E of over 50.
Then the effects of the GFC caught up with Worley; and revenues, profits and earnings per share fell. The share price followed, falling to around $13 before rising as revenues and profits recovered, to where it's currently trading at around $28.76.
Extrapolation can be dangerous
Matrix Composites & Engineering Limited (ASX: MCE) share price more than tripled to over $9 in just over a year, as expectations of growing profits and earnings would continue. The stock was regarded as one of the "hot stocks" on several stock market blogs.
Then the global down turn came along, new contracts dried up and revenues and profits fell. The share price is now trading around $3.18, and the future looks less than bright.
Walking the tightrope
Campbell Brothers Limited (ASX:CPB) is one of the current market darlings, with the share price rising 64% since September 2011, and over 1000% since 2002. The current P/E is over 25 as net profit has grown by an average of over 30% in the past five years.
The market has very high expectations of the stock, with net profit forecast to rise by over 50% in 2012. While it's likely that 2012 will be an outstanding year for the business, any failure by Campbell Brothers to meet market expectations will likely see the share price slump.
These types of problems rarely come out of the blue – and even if they do, there are some key indicators investors can use to understand the susceptibility of different businesses.
Firstly, revenue, profit and earnings per share growth can mask the actual underlying performance of the company. Investors should pay close attention to return on equity, return on assets and return on capital employed, and how these ratios are trending. Falling returns can indicate the company has taken a turn for the worse.
Cash flows are important – dollars in and dollars out aren't open to subjective accounting treatment. If operating cash flow is consistently low compared to reported profit, you'll want to look deeper.
Profit margins can be a great proxy for margin of safety. If a company has skinny profit margins, it doesn't take much for the company to lurch from a profit to a loss in a very short period of time. Examples of companies in this bracket include Transfield Services (ASX: TSE), Downer EDI (ASX: DOW) and AJ Lucas (ASX: AJL).
Of course, 'normal' profit margins vary by industry, and low margins aren't always bad – a company like Woolworths (ASX: WOW) with revenues of over $54 billion and very dependable, repeat business isn't as risky as a business depending on a discretionary order book for construction or services.
Lastly, high P/E ratios heighten risk for investors. It usually means the market has high expectations and any failure by the company to meet those expectations, will be harshly judged – with commensurate impact on share prices.
The Foolish bottom line
Successful investing is much about buying shares when they are cheap, and offering a margin of safety with good growth prospects.
Treat the 'hot' stocks the way you would with anything else that can cause burns – very carefully indeed.
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Motley Fool contributor Mike King owns shares in Matrix Composites and Woolworths. The Motley Fool's purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson. Click here to be enlightened by The Motley Fool's disclosure policy.