An almost sure-fire way to lose money in stocks

John Dorfman
| Tuesday, Feb. 19, 2013, 12:01 a.m.

One warning signal that reckless investors disregard is extreme overvaluation.

And one compelling sign of that is a stock selling for 100 times revenue.

To be sure, some stocks with that sort of wild price tag do go up, but that is the exception. Losses are common.

That's why I periodically write columns warning about stocks selling for 100 times revenue or more.

Stocks on my warning list from a year ago fell 38.5 percent from Feb. 14, 2012, through Feb. 14. Over the period, the S&P 500 returned 15.3 percent. Both figures include reinvested dividends.

Four of the five stocks on last year's warning list fell. The biggest disaster was Houston American Energy Corp. (HUSA), which dropped 98 percent after problems with a well in Colombia.

Pendrell Corp., an intellectual-property consultant in Kirkland, Wash., fell 51 percent. Its predecessor, ICO Global Communications Ltd., lost a court battle in which it claimed that Boeing Co. (BA) breached a contract to help ICO create a satellite network.

Star Scientific Inc. (STSI) of Glen Allen, Va., a maker of anti-smoking products and nutritional supplements, declined almost 50 percent. The company settled a lawsuit against Reynolds American Inc. (RAI) for $5 million, a fraction of the proceeds it earlier led investors to expect.

Ziopharm Oncology Inc. (ZIOP) fell 9 percent. The sole gainer in the group was Lexicon Pharmaceuticals Inc. (LXRS), which rose about 16 percent.

These results were no fluke.

Over the years, I have compiled eight lists of stocks selling for 100 times revenue or more, beginning in 2000. Six of the eight lists showed losses. Seven of the eight performed worse than the Standard & Poor's 500 Index.

The average return for my lists was a loss of 32 percent; the average return for the S&P 500 was positive 5.9 percent.

There's logic behind this. The average stock sells for about 1.4 times revenue. When shares go for 100 times revenue, it means investors are fantasizing.

Bear in mind that stocks advance by exceeding expectations. It would take success even better than the majority expects to move the stock higher.

At the moment, 0.4 percent of U.S. stocks sell for 100 times revenue or more.

Here are five that meet the deadly description. Four are biotechnology companies, an area where investors can readily imagine huge oaks growing from acorns.

Ariad Pharmaceuticals Inc. in Cambridge, Mass., focuses on cancer treatment, emphasizing drug-resistant or hard to treat cancers. One of its drugs, Iclusig, for leukemia, recently won Food and Drug Administration approval.

Ariad had about $1 million in revenue for 2012, but analysts anticipate $43 million in 2013. The price-to-revenue ratio is 5,700 based on revenue achieved. Based on projected 2013 revenue, it is about 84.

Analysts have high hopes for Iclusig and other drugs in the pipeline. Of 21 analysts covering the stock, 18 recommend it. I am skeptical that it can grow into its valuation in a reasonable time.

Two stocks repeat from last year's list. Cancer specialist Ziopharm Oncology, based in New York, sells for 437 times recent revenue.

Lexicon Pharmaceuticals, the only stock on last year's list that rose, sells for 717 times revenue. The Woodlands, Texas, company is working on drugs for a variety of conditions including diabetes, obesity, heart disease and cancer.

Lexicon's revenue was about $1 million last year and is expected to hit about $16 million this year. The market value of the stock is greater than $1 billion.

Achillion Pharmaceuticals Inc. (ACHN) of New Haven, Conn., is working on drugs for AIDS, hepatitis and other conditions. It is less pricey than the preceding three, but sells for 270 times recent revenue.

The one nonbiotech entry on my list is VirnetX Holding Corp. (VHC), which specializes in secure Internet communications. Revenue was $2.4 million last year and is expected to be $18 million this year. The market value is $1.79 billion. I think VirnetX's niche will attract competition, and high-quality competition at that.

John Dorfman is chairman of Thunderstorm Capital in Boston and a syndicated columnist;

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