NEW YORK (Real Money) -- In order to engage and satisfy my inner geek I spend a lot of time surfing various business school Web sites for new research and interesting projects. One of the more interesting sites is that of the Ross School of Business at the University of Michigan. The Tozzi Financial Center at the school has a site that tracks what it calls earnings torpedoes. Using some basic academic concepts such as value, momentum, quality and predictability, the center looks for stocks that can blow up your portfolio when a negative earnings surprise sends them tumbling. The center has done a good job of finding potentially losing stocks; a long portfolio of these explosive stocks has lagged the market in 10 of the last 14 years.
I previously wrote about earnings torpedoes in March and mentioned two specific stocks that the school listed as potential torpedo candidates. LinkedIn (LNKD) shares fell to about $140 from around $200 in the months after the article, before recovering in the second half of the year. Shares of Yelp (YELP) fell and didn't recover as the decline has extended to less than $60 from a little over $100 per share. It appears that the kids at the University of Michigan are onto something with this list, and it's worth paying attention to these potential portfolio killers.
When I look at the current list of 100 potential torpedo stocks, the most obvious observation is that health care dominates the list. Half of the stocks are in the health care sector. This makes sense. Although health care is and will be one of the stronger sectors of the economy, the valuations have been high for some time. It has literally been years since I could find a health care company that would qualify as a cheap stock based on metrics such as price-to-book value or enterprise value-to-earnings before interest, taxes, depreciation and amortization. A deeper look shows that almost all these stocks are biotech names, which makes sense. The biotechs, especially the smaller ones, reached levels that I consider dangerously speculative a long time ago. Those who do not have a degree in biotechnology or access to one should best avoid these stocks.
Some interesting issues among the nonbiotech stocks could potentially blow up your portfolio. Tesla (TSLA) makes the list of torpedoes. The controversial electric car company has seen its stock more than double in the past year, but there are cracks in the armor. There are concerns about the number of Model X cars it will deliver next year. One analyst cut the delivery estimate by two-thirds and lowered earnings estimates for the company. With a forward price-to-earnings ratio of 85, the company has very little room for error. Should an earnings miss or other unexpected bad news be announced, this stock could fall a long way.