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Sidestepping Danger Before You Hear The Rattle


Cover Story: Where To Invest '96: The Investment Spectrum: Investments To Avoid

SIDESTEPPING DANGER BEFORE YOU HEAR THE RATTLE

Rates are down, stocks are up. The Dow Jones industrial average climbs to ever-higher levels. Initial public offerings and high-tech and financial stocks are rampaging. But there's a flip side to the merriment. Sky-high price-earnings ratios, hype, and investor overenthusiasm can also be found in abundance.

Avoiding overpriced or shaky stocks can be the smartest way of keeping damage to a minimum in the event of a market setback. The Dow may well continue its upward march, but any weakness will bring as its first casualty the stocks that are rising on currents of hot air. The ranks of stocks to avoid range from high- to low-tech, with Internet-related stocks at the top of the list. Net stocks with high valuations and uncertain prospects include such highfliers as NETCOM On-line Communication Services and Netscape Communications. Biotech darling Organogenesis also falls in the category of "don't touch with a 10-foot pole," as does Infinity Broadcasting, the debt-laden radio chain that is home to disk jockey Howard Stern (table). For the most part, these are solid, reputable companies. But they have a way of defying gravity--and it won't go on forever.

BANK ON BANKS. Spotting shares to steer clear of is more than a question of looking at a stock chart or a high price-earnings multiple. For example, money-center banks and savings and loans were among the best-performing stock groups of the year, but that's no reason to avoid them--particularly if the Federal Reserve performs its election-year ritual of keeping rates low. "The bank and thrift groups are likely to remain strong and healthy for quite some time," observes Dale Jacobs, president of Financial Investors Inc., who manages hedge funds specializing in financial stocks.

Internet stocks are arguably the most dangerous stocks to buy right now. The leader, of course, is Netscape, the manufacturer of net-browser software. Its shares have nearly quintupled in price since its initial public offering at 28 in August. Online services and Internet providers such as NETCOM, UUNET, and America Online--which carries an online version of BUSINESS WEEK--have also been hot. But most have fundamental weaknesses that make them dangerous stock picks--and sometimes alluring short-sale prospects. The dial-in services "are about as close as you can come to a commodity," observes Michael Murphy, editor of Overpriced Stock Service, which recommends short-sale candidates. He believes Netscape is also a long-term loser. Net-browser software, still Netscape's chief claim to fame, is a dubious source of revenue, Murphy maintains. "They've gotten a 75% market share by giving their product away. I'd have hoped for 100%," he sniffs.

Until recently, the market has all but ignored the competitive time bomb that faces Internet-service providers. Word of impending competition from Microsoft's network sent all Internet stocks plunging recently. But the threat doesn't end there. Numerous small Internet vendors, ranging from regional outfits such as New York's Pipeline Network Inc. and IDT to even smaller operations, provide access to identical Internet services. For all intents and purposes, they are NETCOM clones. They also pose serious competition for America Online, Prodigy, and CompuServe, where Web access has become an increasingly important selling point. Murphy predicts that Internet-only access will soon be priced as low as $3 to $5 a month--which would be a body blow for all Net-service providers, both large and small.

FRAGILE FLIGHT. Even though these long-term competitive dynamics have escaped notice, the inflated valuations of Net stocks have already made them vulnerable to bad news. All have seen their share prices fall sharply in recent weeks. But they are not necessarily terrific short-sale candidates, either. Until market sentiment toward the Internet fundamentally changes, these stocks will no doubt continue to dazzle with their acts of levitation. They're not available for borrowing in substantial amounts, making them difficult to borrow for short-selling and leaving shorts vulnerable to a short squeeze. "I tried and simply could not borrow [Netscape] stock and couldn't take a short position," laments New York money manager Bob Bandera, president of Westlake Capital.

Internet shorts may well wind up following in the footsteps of one non-Internet favorite of short-sellers, Presstek Inc., a New Hampshire company that's developing new technology for printing-press manufacturers. Presstek stock is up 250% for the year to date, and its p-e is a huge 742--wreaking havoc among shorts, who at times have had short positions on some 25% of the shares outstanding. Presstek, computer-equipment maker Cascade Communications, and Infinity Broadcasting are three recent short-selling picks of Short on Value, a newsletter that recommends stocks based chiefly on their valuation. Win Murray, the newsletter's associate editor, also likes McAfee & Associates, which designs widely-used antiviral software. Murray feels that while the company's growth is impressive--its sales have shown dramatic climbs in recent years--the figures simply don't justify high valuations.

McAfee is a good example of how an otherwise worthwhile company can make the rank of stocks to avoid on the basis of overheated valuation. The same can be said for fast-rising but less pricey companies, including Starbucks Corp., the nationwide purveyor of coffee to the yuppie market, and AMC Entertainment, the movie-theater chain. Cascade Communications, which supplies telecommunications and networking equipment, has begun to show excessively rich market valuations, detractors such as Murray point out.

BUOYED BY FAITH. But again, shorting these stocks can be as hazardous as owning them. All too often, they're as treacherous for the shorts as they are for the longs. Traders who have shorted such short-seller favorites as Copytele, America Online, Presstek, and Organogenesis have gotten burned because the shares have continued to rise on continued investor faith--and the support, sometimes, of major brokerages. Evan Sturza, editor of Sturza's Medical Investment Letter, has long maintained that Organogenesis' skin-graft technology is destined to be a commercial failure, even if it gets Food & Drug Administration approval, because of competition from existing treatments. Sturza makes a persuasive case, but the market has ignored him, and the shares have zoomed in recent weeks simply because the company filed its FDA application.

Sturza dislikes North American Vaccine Inc. for the same reason: Its product under development, a pertussis vaccine, faces stiff competition in a low-margin business. "The market is merciless," Sturza maintains. And an even more rapacious market--the one on Wall Street--doesn't always appreciate that reality. Kindness? No, the operative word is "blindness."By Gary Weiss in New York


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