Why These Are Bubble Stocks

In a market that has returned about 17% so far this year, it is tempting to follow the herd and jump on the hot stocks -- those stocks that have characteristics of rule breakers yet seem eerily similar to many of the hundreds of companies that went bust after the dot-com boom.

Will these companies continue to defy logic and confound value investors? And will they continue to reach new highs based on their potential to deliver results? Or will investor sentiment change, causing these companies to get pummeled?

Just another online company
Zillow
(NASDAQ: Z  )  is an online real-estate database that generates revenue by selling leads to real-estate agents. During the dot-com boom, hundreds of Zillow-like companies went bust, while a select few, such as Amazon, eBay, and Priceline, made it big. Zillow, however, is most likely a bubble about to burst. Zillow's shares have taken off, up almost 250% this year due to Zillow's ability to dramatically increase its user base and generate traffic. At the end of the first quarter, Zillow touted its more than 34,000 premier agent subscribers -- an 80% increase over the previous year. That's a small fraction of the National Association for Realtors' 1 million members, but Zillow competes with Trulia and many others for this potential customer base. And Zillow is likely to post a loss for at least the next few quarters. Still, many believe Zillow has a sound business model that is scalable, and some projections see revenue growing in a range of 35% to 50% for the next five years. Even so, Zillow trades at about $90 per share and at more than 170 times next year's expected earnings. As interest rates continue to rise, Zillow's story will sour and the stock will decline.

A company that can't compete with the big dogs
Telsa Motors
' (NASDAQ: TSLA  )  stock price has taken off -- at the time of writing, it trades at $178 per share and is valued at more than 300 times next year's forecast earnings. Even though the government is subsidizing production of electric vehicles, there are several challenges that even the larger EV manufacturers are unlikely to resolve anytime soon, let alone a small niche player like Telsa. These include limited driving range and "sticker shock." Further, the big dogs are slashing prices on their electric vehicles due to sluggish demand. General Motors, for example, slashed the price of its lower-cost Volt from $40,000 to $35,000 and is leasing the vehicle for a mere $299 per month. All in all, vehicle manufacturers sold less than 8,000 electric vehicles in July of this year, which represents less than 1% of all vehicles sold. In addition to General Motors, Telsa will have to compete with the likes of Volkswagen, Ford, Nissan, Honda, and many other companies that have tremendous advantages, namely in the areas of scale, experience, brand recognition, and manufacturing capability. Unless the price of gas soars, demand for Tesla's vehicles will remain weak for several years to come.

This hot stock will cool off
Chipotle Mexican Grill
(NYSE: CMG  ) continues to grow both its top and bottom line in the 20% to 30% range. Chipotle is one of the few restaurant chains that is growing rapidly. Case in point: Chipotle increased its restaurant count by 15% in 2012 and plans to open another 170 or so restaurants by the end of 2013. Even though Chipotle will most likely grow in the double digits for the next few years, it competes in a hyper-competitive space, and its growth will eventually taper off.

Chipotle's market capitalization is above $12 billion. To put that into perspective, that's about six times the market cap of Cracker Barrel, five times that of Wendy's and Brinker International (known for its Chili's and Maggiano's chains), and about double that of Darden Restaurants (owner of such casual and upscale restaurants as Red Lobster, Olive Garden, Capital Grille, Season's 52, and Eddie V's Prime Seafood). The comparison between Chipotle and Darden, for instance, is revealing. Chipotle brought in less than $3 billion in revenue last year versus Darden's more than $8.5 billion; it earned less than $300 million, while Darden's profit exceeded $400 million; and it paid no dividends, whereas Darden paid a dividend yielding 4.4%. Sure, I can see Chipotle growing and matching Darden on these metrics, and perhaps even surpassing Darden eventually. But it will have to do all that and more to justify a market cap that is twice that of its competitor.

An unprofitable, extremely high-beta stock
MGM Resorts
(NYSE: MGM  ) is one of the highest-beta stocks I could find. Even though MGM grew its top line last year, it did so at the expense of its bottom line and remained unprofitable. To succeed, this company will have to dramatically reduce its expenses and increase its convention activity, which is a significant driver of its profitability. That seems unlikely to happen in either fiscal year 2013 or FY 2014. In fact, it is far more likely that MGM will remain unprofitable for the foreseeable future given weak consumer spending, intense domestic and international competition, and a sluggish economy. With a beta approaching four and a market in need of a correction, I would stay far away from this company, because even a small correction could have a large impact on MGM's stock price.

My Foolish take
These are all intriguing companies whose valuations defy the logic of many value investors. But when boring S&P stocks are returning almost 20% year to date, investors often pour money into some of the hot stocks. Within the next few years, all of the above stocks have the potential to trade at a fraction of their current prices, especially if there is a significant correction in the market.

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Read/Post Comments (5) | Recommend This Article (9)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 20, 2013, at 10:55 AM, dvena wrote:

    "Chipotle brought in less than $3 billion in revenue last year versus Darden's more than $8.5 billion; it earned less than $300 million, while Darden's profit exceeded $400 million"

    Hi Ryan - this particular quote is a double-edged sword. Note that it took Darden's nearly three times the revenue to generate only 33% more profit. This equates to a net income margin of 4.7% for Darden's vs 10% for Chipotle, based on your estimates. CMG is producing profits more efficiently than Darden's. Imagine what it would be like if it had similar restaurant counts! - Just sayin...Danny

  • Report this Comment On September 20, 2013, at 11:15 AM, TMFOpie wrote:

    Hello Ryan,

    I would make sure that you are not paying too much attention to the trees and missing the forest with many of these longer-tail companies. Take CMG for example...they have at least 3, if not more, concepts that they are building out that can have an impact on their business in ways that a typical blunt high-level valuation doesn't capture. Catering, sofritas, pricing, mobile apps, new store concepts, Asian Shophouse, etc. Furthermore, looking at Chipotle's culture and founding led passion, I think it has a significant advantage over other restaurant companies. I encourage you to read about Steve Ells and Monty Moran when you can. And the history of Chipotle.

    These kinds of insights are things that analysts should spend time digging through and learning about, because the greatest winning companies and stocks often have this kind of special sauce that while hard to measure has a significant benefit for investors.

    Cheers,

    Andy

    TMF Opie

  • Report this Comment On September 20, 2013, at 2:07 PM, GVFool15 wrote:

    Ryan,

    While you may be right that the companies mentioned may go down soon, over the long term these are all great companies. CMG, Zillow, and Tesla are all growth companies that even with a big drop will still outperform the market over the long term.

    Consider this: Starbucks fell 40% in 1998, fell another 40% in 2001, and dropped 76% in 2008. Yet SBUX has rewarded shareholders 25% annualized return since 1992. Amazon fell 90% in 2001, yet has amazing returns as well. Zillow, MA, LNKD, MIDD, and WFM all have had major drops, yet are all outperforming the market in the long term.

    What's my point? Yes they could drop, but these are fantastic companies that prove they can innovate and I believe they'll outperform over the long term.

  • Report this Comment On September 21, 2013, at 1:39 PM, RyanPeckyno wrote:

    All understood and acknowledged. In a 500-800 word posting it is impossible to write about all of the factors that should be considered. At any rate, many of these companies are priced to perfection (as well as some of the others mentioned above), and in a fragile economy, all of the companies mentioned above will get crushed on either (1) any so/so news about the company or (2) any bad news about the US economy. Admittedly, Telsa appears to have a very solid product and is a very innovative company. And Europe may provide a fast-growing market for Telsa. But it will have to compete with BMW and many others.

  • Report this Comment On September 21, 2013, at 2:33 PM, RyanPeckyno wrote:

    I'd prefer RE/MAX (to IPO at around $20) over Zillow. Darden Restaurants over Chipotle. BMW over Telsa. And a lot of companies over MGM.

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