HOW TO PLAY IT: High-flyer stocks crash back to earth

Salesforce.com Chief Executive Officer Marc Benioff speaks during a joint news conference with Japan's Toyota Motor Corp President Akio Toyoda in Tokyo May 23, 2011.

Credit: Reuters/Yuriko Nakao

By Aaron Pressman

BOSTON (Reuters) - Investors who favor the fastest growing stocks, those with revenue and share prices accelerating far more quickly than profitability, are getting pummeled as one after another of their favorite stocks slip and fall.

That has hedge fund managers and other short sellers on the lookout for the next high flyer to take a dive.

Salesforce.com, the online software vendor, has been trading at a price-to-earnings ratio of more than 500. It posted a third quarter loss as growth in customer billings had slowed. Its shares lost 9 percent. The shares are now more than 29 percent from their 52-week high of $160.12, reached July 19.

For investors, the Salesforce fall is just the latest to show that high-flying stocks can be vulnerable to sharp pullbacks at the first sign of disappointment.

SHORTING HIGH-FLYERS WHEN THEY FALL

Disillusionment with Salesforce followed a similar fall from grace suffered by coffee packager Green Mountain Coffee and online video service Netflix.

The volatile markets have pushed more and more of the most bullish investors to the sidelines, making the share prices of momentum driven, high-growth companies more vulnerable, some investors said.

"Once it happens to one of them, they all start getting closer scrutiny," said Todd Sullivan, hedge fund manager and co-founder of Rand Strategic Partners in Westborough, Massachusetts.

Sullivan has been shorting Salesforce.com. Typically, short seller sell borrowed shares with the expectation they will be able to cover the loan with shares bought for less in the future. Even with Friday's tumble, Sullivan says the shares have a lot more room to decline.

The company "will see growth slow and, worst of all, costs continue to accelerate," he said. "They ought to see material GAAP losses next year."

Salesforce has lately been emphasizing bottom line results excluding some of the factors required by GAAP, or Generally Accepted Accounting Principles.

"The bloodletting doesn't appear to be over," added Kevin Duffy, a hedge fund manager at Bearing Asset Management in Dallas, Texas.

Many more shares are vulnerable, he said. "There are still plenty of momentum stocks flying high," he said.

Duffy's fund is shorting Salesforce.com along with a few other companies trading at high valuations like retailer Lululemon Athletica and Chinese Internet search provider Baidu. He recently cut back half of the fund's short position in Netflix, initiated when the stock was over $300, as the shares have tumbled to under $80 this week.

To be sure, shorting stocks can be risky. An investor's upside is capped and the downside can be virtually unlimited if the shorted stock continues to rise in price.

GETTING CAUGHT UP IN SECTORS

Excitement about so-called cloud computing, the move from desktop PC applications and storage to Internet-based alternatives, helped boost Salesforce's price to such lofty levels. But there are few barriers to entry in the cloud computing game and competitors large and small are pouring in.

Other stocks benefiting from the cloud hype may be likely candidates to follow Salesforce.com's sharp decline, said Ryan Bend, co-manager of the $1.8 billion Federated Prudent Bear Fund. He is also looking at potential victims of volatility in the smartphone market.

"These kinds of businesses change so rapidly that they shouldn't be capitalized at high multiples," Bend said, referring to the sky-high price-to-earnings multiples many of the stocks carry.

Social media stocks, particularly those that have recently become public or plan to go public soon, are also likely overvalued, Bend said. Finding a broker that will lend shares to sell short can be difficult, however.

"For one of these social media companies, I can't get any shares to borrow," he said. "I sense they will prove very fruitful once they have all come public next year and you can get shares to borrow."

Bend declined to mention specifics, but GroupOn, which went public this month, is trading at a value of almost $16 billion without showing a profit. And LinkedIn trades at a P/E multiple over 1,000, according to several data services.

The fund has already shorted some companies involved in cloud computing including Akamai Technologies, Citrix Systems, F5 Networks and Oracle, according to a September 30 portfolio disclosure report.

WINDOW DRESSING

By contrast, stocks that have done poorly -- the opposite of the fast-rising momentum stocks -- can sometimes prove profitable for short periods, especially at the end of the year.

Portfolio managers engage in a phenomena known as "window dressing," where they sell stocks underperforming into their year-end. Those stocks then tend to rebound after that selling is over and outperform the overall market, according to quantitative strategists at Credit Suisse.

For 2012, CSFB analysts believe First Solar, a stock that had once been among the favored momentum names, will rebound from its losses as it has dropped sharply from its 52-week high of $175.45, lately traded at $45.19.

The sharp fall makes the stock about 50 percent undervalued based on a Thomson Reuters StarMine analysis of expected growth rates. Solar companies have seen their valuations fall due to cutbacks on subsidies in Europe and a glut of solar panel supply that has resulted in a 40 percent fall in the price of solar panels.

Many of the stocks in question come from the banking sector, which is still getting hit due to ongoing worries about the exposure financial companies have to the U.S. housing industry and the European banking sector.