Hi everyone. I’m Tim Melvin, and welcome to A Better Way to Wealth.
As important as it is for us to find great stocks that could make us a bunch of money on the upside and special situations that could generate profits and cash flow, it’s equally important, as we work to pile up wealth over the years, for us to avoid those toxic stocks that can absolutely destroy our portfolio.
One of the key ways for us to identify a toxic stock is to look for companies that have great stories and that have been very popular growth stocks but when you look under the hood, the fundamentals are slipping.
These are companies where business appears to be getting bad and they’re trading at really high valuations that are hard to justify based on the current condition of the business.
You also want to see a sign that other institutions are starting to feel the same way.
How do you find this? Look for “great stories” that are starting to underperform the S&P 500.
Folks, if they were really that great, they should not be underperforming the indexes at any point in time.
Remember, twin momentum can work both ways… If the fundamental momentum is constantly improving and getting better, that’s going to provide price momentum.
But if fundamentals are getting worse, it can provide negative momentum. And if you get negative momentum in a stock that’s starting to underperform with fundamentals that are getting worse, you’ve got the recipe for financial disaster!
First up is a company that I brought to your attention earlier this year, but I want to bring it up again…
I’m talking about the cloud computing software company ServiceNow, Inc. (NOW).
Guys, this software is great! They use artificial intelligence, performance analytics encryption and have been a big hit with businesses all across the United States.
That being said, this stock is trading at absolutely nosebleed levels. It does have a good story and 35% annual sales growth over the last couple of years.
But it’s trading at 23 times sales, 595 times earnings and 89 times earnings if they’re actually able to increase their earnings seven-fold as the analysts think they’re going to do in 2022, which would be quite an accomplishment if they can pull it off.
The stock has been flat since September and is now starting to underperform the broader market. And a closer look shows me that there’s been a lot of insider selling over the last couple months, which is never a good sign for investors.
To me, it looks like we’ve got the recipe here for a major financial disaster…
Fundamentals continue to get worse, the stock is underperforming, we’ve got insider selling and valuations are currently excessive. Guys, nothing good happens at 23 times revenues for even the very best story.
All the elements are in place for something awful to happen to the stock price. It’s a great company, but I just don’t think we should own the stock at this price.
Honestly, if they continue to underperform and the fundamentals continue to slip, this could be a failure of epic proportions, and we certainly don’t want that in the portfolio.
Next up is MicroStrategy Incorporated (MSTR).
Here’s a nice software company with a good business that’s taking all the cash they can get their hands on to buy Bitcoin, currently owning around 124,000 coins valued at around $5 billion depending on exactly where the digital asset is trading at any given time.
Despite this investment strategy, the company’s core business is slipping badly as they took on over $2 billion in debt and issued $900 million in stock to buy Bitcoin.
This is one big levered bet on Bitcoin at this point because the core business is absolutely falling apart.
Keep in mind, leverage cuts both ways… If Bitcoin keeps going up, this stock could turn out to be fantastic. On the other hand, if Bitcoin keeps going down, this stock is going to be a disaster.
It is already underperforming the market rather badly, and the big question in my mind is if they’re so bullish on Bitcoin, why are so many company insiders selling stock into the open market and sticking the cash back in the bank account?
Honestly, there’s just a lot that could go wrong here… Any big correction in Bitcoin, and this stock is going to absolutely collapse.
With that in mind, I’m considering this a potentially toxic stock that we should keep out of our portfolio at this time.
Coupa Software Incorporated
Finally, we have Coupa Software Incorporated (COUP). This stock has already started trending downwards, but I think it’s still got a lot of downside left.
This is a software company that has a very good story… They offer supply chain management opportunities and a pretty good business spending control software… All the things that should make this stock a good bet, and they have been growing.
However, they’re currently at 16 times sales and 209 times what the analysts hope that they’ll earn in 2022!
These hopes seem awfully high though as they were unable to come across the bottom line in 2021 and ended the year without making a profit.
Therefore, I’m considering this to be a potentially toxic stock with their momentum getting worse, and their fundamentals continuing to slip, which will show up in price momentum coming out of the stock and turning negative that has already started to happen.
This is twin momentum in reverse, and there could be massive downside left to this stock. Remember, nothing good happens over 10 times sales.
If you see a company trading over 10 times sales, the fundamentals have to be great and getting better or you’re going to get reverse twin momentum at some point in time, which can take the stock a lot lower than we ever thought it could go.
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