Good Companies Don’t Always Make Good Stock Picks: John Dorfman

As 2010 draws to a close, all of the biggest gainers in the Standard & Poor’s 500 Index and most of the biggest losers look like bad bets for next year.

As of Dec. 14, the index’s best performer for 2010 was Cummins Inc., a Columbus, Indiana, manufacturer of engines and power generators. The stock is up about 136 percent so far this year.

I have owned Cummins for clients on and off over the years. I think the management team under Chief Executive Officer Theodore Solso is sensible and takes the long view. Analysts estimate the company will post diluted earnings per share of $5 this year, a record.

I do not own Cummins currently, however. There is a vast difference between a good company and a good stock. At about $108, I think Cummins is fully priced. It now trades at five times book value (corporate net worth) and 23 times earnings.

Here is a rundown on some other leaders and laggards in the S&P 500 this year:

Akamai Technologies Inc., located in Cambridge, Massachusetts, helps to deliver content and monitor traffic on the Internet. This is a stock in which fortunes have been made, and lost.

From a high of more than $327 a share in 1999, Akamai fell to less than $1 a share in 2002. Since then it has regained traction and risen to about $50. The good-company, bad-stock syndrome applies here. I consider the shares overpriced at 51 times earnings and almost nine times revenue.

In the Clouds

Then there’s Salesforce.com Inc., which is as popular with investors as Akamai was 11 years ago. A leader in cloud computing for businesses, Salesforce saw its revenue grow to $1.1 billion last year from $51 million in fiscal 2003.

Shares in the San Francisco-based company have advanced about 86 percent so far this year.

Computing that involves storing files and programs on a host’s servers is here to stay. It allows salespeople in different cities to share notes and observations easily. Yet I can give you three good reasons not to invest in Salesforce.

First, at 245 times the past four quarters’ earnings, it has huge expectations built into the stock price. Second, analysts expect its fully diluted earnings per share to fall more than 20 percent this fiscal year, ending January 2011, before growth resumes in the next two years. Third, Microsoft is taking explicit aim at its market.

Betting on China

Wynn Resorts Ltd. likewise seems overvalued. The operator of luxury casinos in Las Vegas, its headquarters city, and Macao, China, is priced as a hot growth stock at 83 times earnings. Yet its best earnings result, $5.63 a share, came in 2006. This year analysts expect it to earn about $1.14.

Priceline.com Inc., based in Norwalk, Connecticut, is up about 85 percent. I think it offers a useful online shopping service, and its ads starring actor William Shatner are funny. But pay 12 times book value and 42 times earnings? No way.

One might expect to find better bargains among the S&P 500’s laggards. This year’s crop of underachievers doesn’t excite me much, but I do think there is rebound potential in H&R Block Inc. and Apollo Group Inc.

The biggest loser in the index is Dean Foods Co., down about 55 percent so far this year. The Dallas-based food and beverage company is cheap at eight times earnings, but its debt- to-equity ratio of 271 percent is too high.

Yes, I know dairy products, Dean’s specialty, are supposed to be a steady business that can easily support a heavy debt load. But experience suggests that debt never matters -- until it does.

Rebound Potential

H&R Block, the largest U.S. tax preparer, is down about 43 percent this year. The Kansas City, Missouri, company has problems -- mopping up after a messy foray into mortgage lending, and more competition from sellers of tax-preparation software -- but I think it has comeback potential. At eight times earnings, I believe H&R Block is a good candidate both for a quick January bounce and a good year in 2011.

Apollo Group is down about 36 percent. I wrote about this company and its competitors last month. In my judgment Apollo is more capable than most for-profit education companies of meeting proposed federal standards. Shares in the Phoenix-based company go for seven times earnings.

Debt Heavy

SuperValu Inc., a grocery and pharmaceutical-distribution company based in Eden Prairie, Minnesota, is trading for only five times earnings. That’s tempting, but I worry about the company’s debt, which is almost five times equity. The stock is down about 31 percent.

Finally, PulteGroup Inc., a home builder in Bloomfield Hills, Michigan, is down about 30 percent. I think it will take a while for homebuilders to make money again because of overbuilding from 2000 to 2006 and because of the large number of foreclosed homes now coming onto the market. With debt at 187 percent of equity, and with the company’s earnings still negative, I would wait.

This column has mostly focused on stocks I would avoid. Next week I’ll look at the other side of the coin -- my 10 favorite stocks for 2011.

Disclosure note: I have no long or short positions, personally or for clients, in the stocks discussed in this week’s column.

(John Dorfman, chairman of Thunderstorm Capital in Boston, is a columnist for Bloomberg News. The opinions expressed are his own. His firm or clients may own or trade securities discussed in this column.)

To contact the writer of this column: John Dorfman at jdorfman@thunderstormcapital.com

To contact the editor responsible for this column: James Greiff at jgreiff@bloomberg.net

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