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 (Z 7.98%) 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' (TSLA 2.97%) 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 (CMG 3.87%) 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 (MGM +0.03%) 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.
