Stocks to Avoid: Where the Shorts Are Finding Targets

Despite big drops, many stocks are overpriced

Now that 15 months have passed and stock averages are way off their peaks, the risk of paying too much for a stock is obviously less than it was. But make no mistake, the market is still littered with overpriced shares.

Many of the expensive shares are not necessarily on the path to destruction, but they aren't worth the risk, either. For other pricey stocks, the likelihood of a dive is great enough to attract enthusiastic short-sellers. Shorts take big risks. They borrow shares and sell them, expecting to replace them at lower prices. If they are wrong, their losses are virtually unlimited, mounting as the shares go up.

Steve Worthington, a short and hedge-fund manager at Barbary Coast Capital Management in San Francisco, says he's having no trouble finding stocks poised to plunge, such as Harley-Davidson (HDI ) and Pinnacle Holdings (BIGT ). And he's noticing other issues that investors should just skip. Avoid, he says, "anything in telecom equipment." Those stocks are still trading on too much optimism, he says. Take Tellium, a startup optical switch company that went public in May at $15. The shares shot to $29.73 and a market value of $3.2 billion even though Tellium has only three customers.

QQQ CRAZE. Since tech stocks and Nasdaq have fallen so much, aren't they cheap? No, says David Winters, research director and a portfolio manager at Franklin Mutual Series Funds who does not sell short. The Nasdaq 100 index of the market's biggest companies trades around 77 times 2001 earnings estimates, according to Thomson Financial/First Call. That price-earnings ratio is three times the p-e on the Standard & Poor's 500-stock index. Yet the index still attracts crowds to the symbol (QQQ ), the exchange-traded funds holding Nasdaq 100 stocks. "People continue to buy the triple-Qs as a speculative vehicle. I think that's nuts," says Winters.

One stock that's down but not cheap is (AMZN ), says Jeff Matthews of hedge fund Ram Partners in Greenwich, Conn. It is off 88% from its December, 1999, high of 106.69. Amazon's core business of selling books isn't growing, and it is still learning to sell other products. He expects its debt will be restructured at the expense of stockholders. Avoid it, Matthews says.

Worthington says restaurant chain Outback Steakhouse (OSI ) and credit-card issuer Metris (MXT ) are vulnerable if the economy slows more and hurts consumers. Outback shares depend on earnings growth that will be hard to achieve as customers scale back. Shares of Metris, which issues credit cards to higher-risk households, jumped 44% in April and May. They're poised to plunge if loan losses surge, Worthington says. The company counters that it won't be a big loser in a recession because of loan limits on its accounts.

ACT Manufacturing (ACTM ) is a longtime target of short Marc Cohodes of Rocker Partners. Shares of the contract manufacturer of telecom equipment are down to $12.15, from $71.38 in September. Cohodes says they'll keep falling. ACT is especially vulnerable to the tech slowdown because it is heavily indebted and a second-tier player. Cohodes also sees more pain for holders of Cree (CREE ), a maker of blue and green light-emitting diodes for signs and handsets. The shares have fallen 69% in the past year. Product prices are falling, and the diodes are becoming a low-margin commodity, he says. The company says it has unique new products coming out that will drive earnings higher.

Outside of tech, shorts see other opportunities. Cohodes cites retailer Hot Topic (HOTT ), which sells faddish clothes for the MTV crowd. Same-store sales growth has cooled fast, and so will the stock, says Cohodes. The company says that earnings will still be up more than 20%.

BOOMER BUST? Worthington is short another consumer stock, Harley-Davidson. Harley's brand is great, but so is the p-e on its stock, at 34 times estimated 2001 earnings. Its revenue growth slowed to 13% in the first quarter, from 22% a year earlier. It would have slowed even more, Worthington says, if Harley's dealers had not taken more bikes into their showrooms. And, he notes, delinquency rates on loans to Harley customers rose to 5.15% in 2000 from 4.07% in 1998, suggesting that the company is not finding as many creditworthy buyers as it needs for growth. Harley has sold so many bikes to baby boomers, its core customers, that slowing growth is inevitable, Worthington argues. The company says demand and growth remain strong and that critics don't know what they're talking about.

Speculation like that seen with dot-com stocks thrives now among alternative-energy issues. Shares of FuelCell Energy (FCEL ) recently traded at a market capitalization of $1.2 billion despite the fact that the 32-year-old company has no earnings and has made sales for trial use only. Indeed, the company won't make an annual profit before 2004, and then only $20 million on $420 million in revenues, according to a bull on the stock, Sanjay Shrestha of FAC/Equities. The company's chief financial officer, Joseph Mahler, says buyers of the stock understand that the company will be making a lot more money by 2006. Its fuel cells are an answer to industry's need for clean, on-site power, he says. The cells make electricity from natural gas without the smoke from combustion. Shorts say that even if the technology works, which they doubt, the stock will crater before the company ramps up production.

Meanwhile, some stocks roam the market like the living dead. Shares of Pinnacle Holdings, operator of towers for cell-phone and pager networks, look like they've still got life at $4.80, down from $80 in March, 2000. But Worthington says they're worse than dead money. The company needs to buy or build more towers but is heavily indebted. Raising new money is impractical because of a pending accounting investigation, which the company acknowledges in public filings. Ethan Schwartz, principal at CRT Capital Group, says the stock might be worth only $1.75 after subtracting its debt from an optimistic assessment of its assets. More likely, if there were a reorganization, the shares would be worth essentially nothing, he says. But you don't have to rely on his word. The debt market has reached the same conclusion: Pinnacle's convertible notes trade around 47 cents on the dollar.

With hazards like these still in the market, let the buyer beware.

By David Henry

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