What are we looking for?
High fliers that might be ready to flame out.
Last week the S&P 500 hit a new record high. However, despite almost daily triumphant tweets from the U.S. President, troubling signs abound – from a trade war with the world’s second-biggest economy, to much lower than expected job growth in May, to the changing shape of the yield curve. For investors who find these signs troubling, and might want to lock in profits, we will look for companies that have helped propel the S&P 500 to these uncharted heights, but may be flying a little too close to the sun.
First, we look for companies that have posted a return of at least 30 per cent year-to-date (the S&P 500 has returned 17.5 per cent).
Among these, we look for those that might be overvalued, according to Refinitiv’s StarMine valuation models. The Intrinsic Value Model looks at the current market value of the company relative to the time-discounted value of estimated future cash flows (the further out the forecast, the more the discount). The Relative Value Model compares a company with its peers in terms of market price relative to forward and trailing earnings, sales, cash flow, etc. For each model, we look for companies that are in the bottom 50 percentile range in the U.S. market.
Next, we look at the Refinitiv StarMine Short Interest and Earnings Quality models. The Short Interest Model identifies companies where a significant proportion of institutional investors, or the “smart money," have actively bet against the stock (lower short interest means a higher score). The Earnings Quality Model looks at things such as:
- Is the company generating hard cash, or only profits on paper?
- Are expenditures being excluded because they are deemed “special items” or “non-recurring?"
- Is the company accruing accounts receivables or “IOUs” from clients and booking them as sales, or delaying payments the company owes to suppliers or others?
These things together give a signal of earnings quality – how sustainable reported earnings really are. Again, we identify companies in the bottom 50 per cent for the U.S. market.
More about Refinitiv
Refinitiv, formerly the financial and risk business of Thomson Reuters, is one of the largest providers of financial markets data and infrastructure, serving more than 40,000 institutions worldwide. With a dynamic combination of data, insights and technology, as well as news from Reuters, our customers can access solutions for every challenge, including a breadth of applications, tools and content – all supported by human expertise.
What we found
The screen yields four companies and the one with the worst score in three of the four models, and the only one scoring single digits on any model – Netflix Inc. – is probably the most familiar to many readers. Netflix has returned 38.6 per cent already this year as domestic and international net subscriber additions, revenue and income for the first quarter all came in ahead of both the Street’s expectations and company guidance. However, average revenue per unit (ARPU) – in other words, per subscriber – was more than 6-per-cent lower than expected.
The company is also burning through cash as it tries to enhance its offering of original content. Netflix last had positive free cash flow (FCF) in 2011. FCF has decreased every year since; last year, the company burned through cash at a rate of US$3-billion. This means Netflix will either have to continue this impressive pace of subscriber additions or raise their prices at some point in the near future – all in an increasingly competitive market.
Walt Disney Co., AT&T Inc. and Comcast Corp. are all getting into the video-streaming business, and all already have a valuable suite of original content – much of it now streaming on Netflix. (Disney owns Fox and ESPN, AT&T owns Warner Bros. and Comcast owns NBC/Universal.) In fact, according to tech news website Recode, the six most popular programs on Netflix, and 11 of the top 13, are all owned by other companies entering the streaming game. If these companies don’t renew Netflix’s licence to the content, the path forward for Netflix could become much more difficult.
Investors are advised to do their own research before trading in any of the securities shown here.
Hugh Smith, CFA, MBA, is the manager of Refinitiv’s Investment Management business for the Americas.
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