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Nine Stocks That Only Short Sellers Should Love: John Dorfman

February for me is the grumpiest month.

Perhaps that’s why at this time of year I’ve often compiled a list of stocks to avoid, calling it the Nonsensical Nine.

The securities are chosen using a computerized screening process. I start with the universe of U.S. equities with a market value of $1 billion or more, and a price that is at least three times book value (corporate net worth per share). As of Feb. 2, 534 stocks qualified.

Then I used Bloomberg software to find the three companies that sold for the highest multiple of earnings and the three that sold for the biggest multiple of per-share sales. These stocks are priced on the assumption that everything will go right for them.

Finally, I added the three companies with the most debt relative to stockholders’ equity. High debt leaves little room to maneuver if things don’t go according to plan.

As a warning list, this compilation has a decent record. Over the years a total of 54 stocks have received this designation. Their average 12-month performance has been a loss of 1.6 percent, including dividends. For comparison, the Standard & Poor’s 500 Index returned an average of 5.3 percent over the six one-year periods following publication of prior lists.

Stop Signs

People who hold these shares should review their positions, potential buyers should be wary and short sellers hoping to profit from a stock’s decline should take note.

The analysis used diluted earnings per share excluding extraordinary items.

The highest price-to-earnings ratio belongs to Legacy Reserves LP, an oil and natural gas limited partnership based in Midland, Texas.

In the past four quarters, Legacy’s earnings totaled a penny a share, as two losing quarters almost canceled out two profitable ones. The stock trades for about $29 a share, so the trailing 12-month P/E ratio is about 2,900.

As with many energy partnerships, Legacy’s main charm is its dividend yield, currently 7.2 percent. Still, I consider the shares overpriced. In addition to that startling P/E, the price-to-sales ratio is high, at 5.7.

Allergan Inc., an Irvine, California, health-care company, had the second-highest P/E. Its stock price of about $71 is almost 1,200 times its recent depressed earnings.

Too Pricy

In its best year, 2009, Allergan earned $2.78 a share excluding extraordinary items. The current share price is 26 times that figure, suggesting that the stock is pricier than it should be.

Ultimate Software Group Inc. of Weston, Florida, had the third-highest P/E ratio, well over 800. The company, which sells payroll and human-resources software, saw its shares rise to about $51 from about $32 during the past six months. Executives at the company deny a published story that it’s for sale.

Even if it is acquired, I doubt that Ultimate Software will fetch a fat takeover premium. The stock already sells for fancy multiples of book value (20) and sales (almost six). Yet the company lost money in seven of the 10 years through 2009.

The highest price-to-sales ratio in the group belongs to Pharmasset Inc., a Princeton, New Jersey-based pharmaceutical company. Its primary focus is developing drugs to treat human immunodeficiency virus (HIV) and hepatitis C.

No Profits

In its last fiscal year, Pharmasset’s revenue was about $1 million, yet the market awards it a $1.8 billion valuation. It has issued stock six times since early 2007. If investors ever lose their appetite for the company’s shares, I figure Pharmasset would burn through its $127 million cash hoard in two or three years.

Two biotech companies have the second- and third-highest price-sales ratios. Seattle-based Dendreon Corp., which specializes in developing therapies to treat cancer, sells for 218 times sales. Vertex Pharmaceuticals Inc., located in Cambridge, Massachusetts, goes for 56 times sales. Like many biotechs, these haven’t yet seen any annual profits.

Then we come to the debt measurement. Tenneco Inc., an auto-parts maker based in Lake Forest, Illinois, had the highest debt-to-equity ratio, about 260 to 1, as of Feb. 2. Six of 11 analysts who follow Tenneco rate it a “buy.” However, stock sales by Tenneco insiders have increased in the past year. I’ll look for my auto-parts investments elsewhere.

Debt Burden

Alliance Data Systems Corp., located in Plano, Texas, has a debt-to-equity ratio of about 81 to 1. The company manages more than 80 branded credit-card programs for retailers and airlines. Conventional wisdom says that a steady business can support a lot of debt, and that bromide may apply here. Nevertheless, this debt level makes me uneasy.

Dallas-based Energy Transfer Equity LP is a publicly traded limited partnership that transports and stores natural gas. It also operates a propane distribution operation. Its debt is about 54 times equity. Again, it’s a steady business, but debt ratios of this kind leave little room for error.

Disclosure note: I have no long or short positions in any of the stocks discussed in this week’s column. The spouse of one of my partners works for Vertex.

(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.)

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