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These 3 Stocks Are Priced For Perfection. Can They Deliver?

By Jeremy Bowman - Feb 6, 2018 at 9:43AM

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With the market showing signs of collapsing, growth stocks could be especially vulnerable. Can these stocks deliver on investors' expectations?

The S&P 500 rose a remarkable 45% over the last two years, but after a strong January the U.S. stock market has begun convulsing with the S&P 500 losing nearly 7% in just two sessions.

Those steep gains seem to have given some investors vertigo. A couple of weeks ago at the World Economic Forum, the CEO of Allianz, one of the world's biggest insurance companies, told CNBC that it was "absolutely clear" that a market correction was coming. Peter Oppenheimer, chief global equity strategist at Goldman Sachs echoed those concerns, saying it sees a "high probability" of a market correction. 

The S&P 500's P/E ratio, commonly considered the best way to determine the valuation of the market, is 26.3, the highest it's been since profits crashed during the financial crisis, and well above its historical average of 15.7. 

No one can know for sure when a correction is coming, but if one happens, high-priced growth stocks are likely to take the biggest hits. Below are three stocks that are priced for perfection. Let's take a look at Snap Inc. (SNAP -0.95%)Shake Shack (SHAK -2.82%), and Tesla (TSLA -0.32%) to see if they could get crushed.

A man looking at his wallet as dollar bills fly away.

Image source: Getty Images.

1. Snap Inc.

You may be thinking that Snapchat-parent Snap Inc. is more of a value play these days now that its stock has pulled back more than 50% from the post-IPO highs it hit nearly a year ago. However, shares could still fall considerably further. Snap is a profitless start-up with an unproven business model, competing for ad dollars with tech titans like Facebook and Alphabet. The stock has fallen by double-digit percentages following each of its three earnings reports as a publicly traded company, but shares have traded sideways for the last six months as investors have maintained hope in its future. Revenue growth was still strong in its most recent quarter, increasing 62% to $208 million, but that's a deceleration after it more than doubled earlier in the year. Meanwhile, its net loss more than tripled to $443 million, and daily average user growth has slowed as well, increasing just 3% sequentially to 178 million last quarter as Instagram Stories surged past it in popularity.

Still, Snap stock remains priced as if the company will continue its strong growth and eventually deliver meaningful profitability. It carries a market value of $16 billion, and trades at an eye-popping price-to-sales ratio of 19. To unlock profits, the company has made efforts recently such as opening its "walled garden," or allowing its content to be consumed outside of its properties,  but it's still ceding momentum to Instagram, and advertisers say they greatly prefer Facebook's photo-sharing app over Snapchat. The stock is starting to resemble Twitter, which also struggled to convert its user base into profits, and lost as much as 80% from its post-IPO high to its nadir in 2016. I'd expect Snap's rough earnings streak to continue. Eventually, the stock will have nowhere to go but down.

A Shake Shack burger and hot dog

Image source: Shake Shack.

2. Shake Shack

Like Snap, better-burger chain Shake Shack also appears to be priced for perfection. And while 30% of Snap's shares are sold short, investors are betting even more heavily against Shake Shack with 57% of its float sold short.

However, Shake Shack has bucked those bearish bets recently. The stock jumped 28% since Sept. 1, propelled by the anticipated benefits of the corporate tax cuts, an upgrade from Morgan Stanley, and enthusiasm over a strong holiday season in retail. That rally has only made Shake Shack shares pricier; it now trades at a P/E of 71. 

The burger chain is different from most restaurant stocks though. Comparable-store sales at the fast-casual chain have declined in 2017, falling 1.9%. For a  normal growth stock, that would be cause for alarm, but e Shake Shack's average unit volumes are already tops in the industry, around $5 million, meaning new stores are a more important growth driver than same-store sales, and management keeps accelerating store openings. It plans to open 32 to 35 new locations in next year, increasing its store base by more than a third. Shake Shack's restaurant-level operating margin also slipped last year due to higher labor costs, which caused earnings growth to moderate.  However, its results still consistently beat analysts' estimates. 

While the stock could pull back from recent highs, the GOP's tax cuts should help drive earnings growth over the next year along with the new store openings. Its lofty valuation means there's still a downside risk, but Shake Shack's growth plan looks solid.

The Tesla Model 3

Image source: Tesla.

3. Tesla

There may be no greater battleground stock in the U.S. market than Tesla. The automaker's valuation surged on successful releases of vehicles like the Model S and Model X, and enthusiasm for the company's strengthening position in renewable energy as it builds out its Gigafactory and has taken control of SolarCity. However, considering the company now has a market value greater than Ford and nearly equal to General Motors, but with far less revenue and no profits, it's clear the stock is priced with hgih expectations. At this point, it seems like Tesla needs to prove it can be more than a car maker in order to deliver value for shareholders, as auto stocks like GM and Ford generally carry low valuations.

Tesla is currently embroiled in "production hell" as founder Elon Musk dubbed it, as it struggles to meet the manufacturing goals for the Model 3, its first mass-market vehicle. Reports have mostly indicated that the company has been unable to keep up with its delivery schedule for pre-orders. 

In its most recent update on Jan. 3, the company said it had reached run of 1,000 cars per week by the end of December, but it had originally aimed for a run rate of 5,000 cars a week by that time. Now, the company has pushed that goal back to June. 

Even if production lags, demand for Tesla's vehicles is a reminder of the strength of the brand; the company received more than 500,000 pre-orders for the Model 3.

Tesla had its share of setbacks last year, but the stock's recovery shows that investors are willing to give it the benefit of the doubt as it invests in the Gigafactory, its supercharger network, and speeding up Model 3 production. As such, the stock looks safer for now than its valuation indicates. 

All three of these stocks could get hit in a market pullback, but Shake Shack and Tesla seem to be safer plays, as both the burger chain and the electric automaker have demonstrated that there's high demand for their products. Snap, meanwhile, continues to be at the mercy of advertisers, rivals, and a fickle user base, which haven't treated it well in its short life as a public company.


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Stocks Mentioned

Tesla, Inc. Stock Quote
Tesla, Inc.
$734.76 (-0.32%) $-2.36
Shake Shack Inc. Stock Quote
Shake Shack Inc.
$41.01 (-2.82%) $-1.19
Snap Inc. Stock Quote
Snap Inc.
$14.56 (-0.95%) $0.14

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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