Despite mixed signals from China's economy and a biotech swoon, it doesn't seem anything can put a dent into the side of the S&P 500 following its five-year-plus run. For skeptics like me, that's an opportunity to see whether companies have earned their current valuations.
Keep in mind that some companies deserve their current valuations. Take US Bancorp ( USB -1.13% ), for example. This regional banking giant may appear to be a bit frothy at more than two times book value, but it's kicking around its competition with a return on assets of 1.6%, which is significantly higher than that of national financial institutions like Bank of America and Citigroup. Furthermore, because US Bancorp focuses on the bread and butter of banking (i.e., loans and deposits) and avoids derivatives trading, it's considerably easier for the average investor and Wall Street to understand.
Still, other companies might deserve a kick in the pants. Here's a look at three that could be worth selling.
A risky bet
The biotech sector in general has delivered some breathtaking returns to investors over the past couple of years. However, it has also brought some less-than-savvy biotech traders out of the woodwork who don't quite understand the intricacies of biotech investing. One company in particular that may be way ahead of itself when it comes to its valuation is small cap Transition Therapeutics (NASDAQ: TTHI).
Transition does have some positives going for it. First of all, it recently reacquired full rights to lead drug candidate ELND005 as a treatment for Alzheimer's disease agitation and aggression, as well as bipolar disorder from Perrigo. To add, Perrigo also took a 7% common equity stake in Transition. In addition, it announced last year that struggling big pharma Eli Lilly exercised its rights to handle all development and commercialization aspects of TT-401 for type 2 diabetes.
While I wouldn't turn a blind eye to these developments, I would caution that they're extremely early-stage and probably not worth Transition's current valuation, which has ballooned by close to 300% in the trailing year.
First we have to consider the poor success rate of any Alzheimer's disease therapy regardless of whether it's developed by a small-cap biopharmaceutical or a big-pharma giant. The fact is few Alzheimer's disease therapies meet their late-stage endpoints, making an investment into early- and mid-stage data usually a bad idea for investors.
Also, we're looking at a company with only a handful of phase 1 studies that are complete and an equally small number of planned or ongoing phase 2 studies. Sure, that leaves Transition a lot of catalysts, but we have very little efficacy data to go off of thus far. If you strip out the big-name collaborations, Transition hasn't done very much to impress investors. While it very well could succeed, it's best not to count your chickens before they're hatched.
Banking on history
I usually don't buy the adage that history repeats itself, but when it comes to electronic design automation (EDA) licensor Cadence Design Systems ( CDNS 0.81% ), I'm a believer.
Cadence fills a unique niche within the technology sector in that it helps tech companies take their integrated circuit and electronic devices from concept to reality through its line of software and hardware products and intellectual property licenses. In short, when the tech sector is booming companies are more willing to spend money on R&D, which fuels Cadence's EDA demand.
Yet I have a couple of concerns about Cadence's growth potential moving forward. First and foremost, as I mentioned above, I'm banking on Cadence's practically clockwork-like cyclicality, which signals a peak in its business model about every five years. Given that its last trough was during the recession, we're right around that five-year mark. Adding more fuel to the fire, Cadence went from continuously topping Wall Street's EPS expectations to merely meeting them for the past two quarters. Not to mention that its sales growth is modestly slowing year-over-year.
Another worry I have is China's erratic growth rates. According to Cadence's annual breakdown it received 20% of its full-year revenue from Asia and 13% from Japan. Japan's electronics industry has delivered tepid results for years, but China's slowing GDP growth and weaker manufacturing data could spur a spending reduction across a number of sectors in the region, including technology.
Like Transition, I wouldn't write off Cadence, and I believe the company can be successful given its conservative management team. However, I would also suggest investors realize that it has a clear cyclical streak, and based on that timeline and its slower growth prospects is probably due for a cyclical downturn fairly soon.
No one at the helm
Finally, we have AeroVironment ( AVAV 6.04% ), a developer of unmanned aircraft (i.e., drones) and electric-vehicle charging systems.
As Foolish alternative-energy guru Travis Hoium pointed out earlier this month, AeroVironment is perfectly hitting two very hot niches with regard to drones and electric vehicles. For the recently reported third quarter, unmanned aircraft systems (UAS) revenue soared 53%, with gross margins spiking up to 40%. Making matters even more exciting for AeroVironment investors, the company announced a partnership with Lockheed Martin ( LMT 0.59% ) in February to integrate Lockheed's mission systems with AeroVironment's Global Observer drone, which can fly as high as 12 miles and stay in the air for a week at a time. It's certainly a story stock that's developing at just the right time.
The problem with story stocks is they often don't reflect the underlying fundamentals very well, as is the case here with AeroVironment. Take its 53% growth in UAS revenue this past quarter as a shining example. You might be under the impression that revenue growth is soaring from drones, or that its energy segment is seeing huge orders, with EVs taking the road faster than ever. However, a closer look at revenue through the first three quarters actually shows a 4% decline in total sales! In fact, revenue growth in fiscal 2014 and 2015 is expected to be a paltry 3% despite a company currently valued at 70 times forward earnings.
The real question mark here is what happens with government spending moving forward? It's pretty apparent that the U.S. has no problem spending big money on defense, but even the Defense department's budget is likely to see cuts in the coming years as the federal government looks to pare back years of big deficits. What this could mean for AeroVironment is lumpy revenue recognition. In other words, investors should be prepared for turbulence.
With shares up around 80% over the past six months and revenue growing in the low-to-mid single-digits, I believe it's time to stop flying blind and ditch this stock for something with a better risk-versus-reward profile.