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What to Buy and Sell as the Market Climbs

James is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Recently the Dow Jones has been flirting with 5 year highs.  While the run has been great it has left some of my favorite companies looking a bit expensive.  It has also made it far more difficult to find buying opportunities.  Here I will examine two companies that I believe are in danger of becoming too expensive and one buying opportunity that I believe represents great value.

Visa

It's always tough to sell great companies, but it sometimes becomes necessary when the market offers a premium compared to historic averages.  While I personally believe Visa (NYSE: V) is a great company, its valuation lately has left me a bit concerned.  I will admit that Visa is deserving of a slightly higher premium than the competition. However, how much higher is open to debate.  With the stock climbing over 36% in the last year alone it could be time to take profits.

Looking at some key valuation metrics (Figure 1) we can see that compared to the rest of the industry Visa is commanding a hefty premium.

Figure 1:

<table> <tbody> <tr> <td>Valuation</td> <td>Visa</td> <td>Industry Average</td> </tr> <tr> <td>P/E</td> <td>63</td> <td>37.80</td> </tr> <tr> <td>Price/Sales</td> <td>11.84</td> <td>2.84</td> </tr> <tr> <td>Price/Book</td> <td>4.60</td> <td>4.80</td> </tr> <tr> <td>YoY EPS Growth</td> <td>25.70%</td> <td>56.60%</td> </tr> </tbody> </table>

But let's take a look at the other side of that trade and examine just why so many people are optimistic on Visa. Visa has the largest user base.  They have the largest dollar amount per transaction.  Finally, they maintain a whopping 5 year average net profit margin of 29.20% vs an industry average 7.40%.

Estimates for Visa are rising and if estimates for the FY of 2013 hold true Visa could earn as much as $8.51, which given their extraordinarily high P/E could put their stock price at $536.  That's quite a potential return. But remember that one minor mistake could spell disaster.

While Visa is a great company it is currently priced for perfection.  Meaning any sort of bad news could have a severely negative impact on this stock.  A stock priced for perfection is generally my indicator to sell, or at least introduce a trailing stop. Given past price fluctuations it looks as if a 6-8% trailing stop will keep you safe from minor market moves but get you out in time if the big drop does hit.

Netflix

There is sometimes a singular event or unique scenario that can present a profit taking opportunity.  A current example would be the massive rally of Netflix (NASDAQ: NFLX).  Netflix benefited after posting a surprise quarterly result that created a massive short covering rally.  A rally of this nature isn't based so much on fundamentals but rather the need to cover massive short positions, which pushes up the price and triggers even more buying to cover orders.  Looking at a six month chart of Netflix (Figure 2) we can see that this move has been quick and massive after the Jan. 23 earnings announcement.

Figure 2:

<img src="/media/images/user_14634/netflix-6-mos_large.png" />

 

In just a six month time frame this stock has more than tripled from its bottom and almost doubled since the earnings report release date.  This has left Netflix with some less than desirable fundamentals (Figure 3) from a value investing standpoint.

Figure 3:

<table> <tbody> <tr> <td>Valuation</td> <td>Netflix</td> </tr> <tr> <td>P/E</td> <td>667</td> </tr> <tr> <td>Price/Sales</td> <td>2.94</td> </tr> <tr> <td>Price/Book</td> <td>14.25</td> </tr> <tr> <td>Price/Tangible Book</td> <td>-13.94</td> </tr> </tbody> </table>

There are quite a few reasons for becoming a bit bearish on Netflix.  Prior to this move the historic high P/E for Netflix was 460 and this was met with a decline from highs of nearly $300 to lows of $63 in less than one year's time.  It should also be noted that year over year quarterly earnings per share growth was still at a -77.60%. Finally, the earnings report that triggered all the short covering was not a guarantee of future moves such as this one.  It was a small surprise profit as opposed to the small expected loss. The slim profit margin of Netflix (the five year average being 5%) means those earnings numbers will be difficult to increase significantly.

Overall I can't justify owning Netflix for a few reasons.  Its valuation is a huge red flag to any value investor.  The historic price action of Netflix suggests that after significant moves like this one there is going to be a pullback. Finally, if you are one of the lucky ones to have a gain in this position I would advise to take it and run.  Put it in a company with a more attractive valuation, a less competitive atmosphere, and less volatility. 

Buy This Stock

While it can be tricky determining when to sell a stock in this market it can be even more daunting trying to find a stock to purchase for a long term value play.  Indeed my own buy list has been getting smaller and smaller as valuations continue to rise along with the market.

However, one stock is still looks very attractive to me as I've continued to add to my personal position over the last year for an almost 50% gain.  American International Group (NYSE: AIG) has made a turnaround the likes of which belong in the annals of economic history.

In the interest of time I'll summarize some of the more attractive features of this company.

Management:  In August 2009 Bob Benmosche took the helm of AIG. Since then they have repaid all $182.3 billion borrowed from the federal government.  Divesting peripheral assets and refocusing on the core business has proven successful and investors are anticipating stock buy backs or even a dividend announcement coming in the next couple quarters.

Valuations:  Looking at some key valuations (Figure 4) we can see that AIG looks very attractive.

Figure 4:

<table> <tbody> <tr> <td>Valuations</td> <td>American Insurance Group</td> </tr> <tr> <td>P/E</td> <td>2.50</td> </tr> <tr> <td>Price/Sales</td> <td>0.80</td> </tr> <tr> <td>Price/Book</td> <td>0.56</td> </tr> <tr> <td>Net Profit Margin (TTM)</td> <td>39%</td> </tr> </tbody> </table>

On top of those numbers AIG sports a PEG of 0.47, improving RoI and RoA, as well as a tangible book value per share of almost $69.

Future:  AIG has an absolutely huge footprint.  This established giant has also freed itself from government regulation with the repayment of TARP.  Finally, the business model has fundamentally shifted from risky insurance instruments over to more safe and predictable assets.

AIG has been one of my top picks for over one year now and a nearly 50% gain.  But this is just the beginning. This is the proverbial Phoenix rising from the ashes and investors would be wise to pay attention to the legendary recovery that is still in the early stages.

CONCLUSION

The market is always changing and as a result so should your portfolio.  It never hurts to take profits in stocks that have had a great run.  Once valuations become too rich for the long term value investor it only makes sense to sell or put on a trailing stop.  The same fundamentals that attract buyers to a stock are also the same fundamentals one should watch in order to determine when a position no longer fits that value criteria.  We all know it's always best to buy when stocks are inexpensive, but we must also observe the opposite and sell when stocks appear expensive.

 

 


Lulupoopsalot has no position in any stocks mentioned. The Motley Fool recommends American International Group, Netflix, and Visa. The Motley Fool owns shares of American International Group and Netflix and has the following options: Long Jan 2014 $25 Calls on American International Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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