Biggest gainers not always best investments

John Dorfman
| Monday, Oct. 29, 2012, 11:02 p.m.

Arena Pharmaceuticals Inc. (ARNA) and Pharmacyclics Inc. (PCYC) have quadrupled this year. Lumber Liquidators Holdings Inc. (LL) has tripled.

These are the biggest gainers this year through Oct. 26 among the 1,746 stocks with a market value of $1 billion or more. Twenty-four other stocks in this group have doubled or better, led by 3D Systems Corp. (DDD) with a rise of 196 percent and PulteGroup Inc. (PHM) with a 174 percent gain.

Every one of these five companies is an interesting company. But in my opinion at least four are overvalued stocks.

Arena, based in San Diego, Calif., has developed an anti-obesity drug called Belviq and teamed up with a large Japanese pharmaceutical company, Eisai, to market it. In June, the Food and Drug Administration approved the use of Belviq. As a result, Arena shares have soared from $1.87 a share to $8.46.

Obviously, the potential market is huge, with perhaps 500 million people worldwide suffering from obesity. But I don't recommend jumping onboard.

Belviq is not the only anti-obesity drug on the market, and concerns remain — within the FDA and among doctors — about whether it may cause heart-valve leakage as a side effect. The evidence is inconclusive.

With debt eight times stockholders' equity and with the stock selling at 50 times revenue, the risks in Arena are high. Like a long shot at the race track, it could pay off big. But I don't like the odds.

Pharmacyclics Inc., Sunnyvale, Calif., is a biotechnology company that is working on cancer treatments. Its flagship drug is ibrutinib, to combat lymphoma.

The company's revenue comes mainly from Johnson & Johnson, which is funding the development of ibrutinib and will receive half the revenue from the drug if it is approved.

Pharmacyclics is debt-free, which I like. But the price-earnings ratio of 440 and price-sales ratio of 52 give me the shivers. Ibrutinib has shown good results in Phase 1 and Phase 2 clinical trials, but hasn't completed Phase 3, the most important.

Lumber Liquidators, Toano, Va., retails hardwood flooring and has shown steady progress in revenue, marching from $405 million in 2007 to an estimated $798 million this year.

Earnings progress has been less steady, but good this year. The company is expected to earn $1.58 a share this year, up from 93 cents a share last year. The company is debt-free and is a play on a housing recovery.

Unfortunately, the stock is no longer undiscovered. After tripling this year to about $53, it trades at 36 times earnings. Most analysts rate it a hold. Personally, I would take some profits in it.

3D Systems Corp., from Rock Hill, S.C., is in the red-hot business of 3-D printing. With this technology, an engineer can not only visualize a device in three dimensions, he or she can construct a model of it.

This year, analysts figure 3-D Systems will earn about $41 million on revenue of about $351 million. The stock market values the company at $2.4 billion, which works out to about 57 times earnings and nearly seven times sales. That's too rich, in my opinion.

PulteGroup, Bloomfield, Mich., is the nation's second-largest home builder by stock-market value, just a whisker behind Lennar Corp. (The two are so close that the order could change before you read this.)

Pulte looks expensive if you judge by the price-earnings ratio (35) but not if you judge by the price-sales ratio (1.5). I like homebuilders as a group now. For my clients, I own NVR, the fifth-largest builder and the parent of Ryan Homes.

Reason: NVR is almost debt-free, while Pulte has debt equal to 159 percent of stockholders' equity. Most homebuilders have debt similar to Pulte's or higher.

I can see why any of these five stocks might appeal to growth investors. As a value investor, I find them all too expensive, with the possible exception of Pulte.

It is possible that one, or perhaps even several, of these stocks will keep right on rising. I wouldn't count on it, though. The old Wall Street adage applies: Even trees don't grow to the sky.

By the way, the fact that 27 stocks have doubled or more this year shows that the market climate has been better than many people suppose. The average stock has gained about 9 percent despite the European debt crisis, slowing growth in China and a feeble U.S. economic recovery. Since the stock market is usually a leading indicator, that may presage a better economy ahead.

John Dorfman is chairman of Thunderstorm Capital in Boston;

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