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Options, Stocks, Trading  | July 23, 2020

Distinguishing between overpriced stocks and fairly priced stocks is the key to successful investing. But the task is not easy as the correctly priced and overvalued stocks are mingled in a very deceptive way in the marketplace. However, investors who can pinpoint the overhyped toxic stocks and discard them at the right time are the ones that are poised to benefit.

Usually toxic companies are vulnerable to external shocks. These companies are burdened with huge debts too. Also, unjustifiably high price of the toxic stocks is short lived as their current price exceeds their inherent value. Quite naturally, these stocks are bound to result in loss for investors over time.

Higher price of the toxic stocks can be attributed to either an irrational exuberance associated with them or some serious fundamental lacuna. If you own such stocks for long, you are likely to see a big loss in your wealth.

If you can, however, precisely spot the toxic stocks, you may gain by resorting to an investing strategy called short selling. This strategy allows you to sell a stock first and then buy it when the price falls.

While short selling excels in bear markets, it typically loses money in bull markets.

So, just like figuring out stocks with growth potential, identifying toxic stocks and discarding them at the right time is the key to shield your portfolio from big losses or make profits by short selling them.

Screening Criteria

Here is a winning strategy that will help you identify overpriced toxic stocks:

Most recent Debt/Equity Ratio greater than the median industry average: High debt/equity ratio implies increased leverage. High leverage indicates a huge level of repayment that the company has to make in connection with the debt amount.

P/E using 12-month forward EPS estimate greater than 50: A very high forward P/E implies that a stock is highly overvalued.

% Change in F (1) and F (2) Estimate (12 Weeks) less than -5: Negative EPS estimate revision for this fiscal year and the next during the past 12 weeks points to analysts' pessimism.

Zacks Rank more than or equal to #3 (Hold): We have not considered Buy-rated stocks that generally outperform the market.

Here are five of the 26 toxic stocks that showed up on the screen:

HealthEquity, Inc. HQY: Headquartered in Draper, UT, HealthEquity provides integrated solutions for health-care account management, health reimbursement arrangement and flexible spending accounts for health plans, insurance companies and third-party administrators in the United States. Over the past 60 days, 2020 earnings estimates for this Zacks Rank #5 (Strong Sell) company have declined 16% to $1.47 a share. The metric suggests year-over-year fall of 15%. Holdings, Inc. ALRM: Vienna-based offers interactive security solutions including image sensor, crash and smash protection, web control, mobile access, as well as video monitoring for home and business owners. Over the past 60 days, 2020 earnings estimates for this Zacks Rank #4 (Sell) company have declined by a penny to $1.40 a share. The metric suggests year-over-year fall of 9.1%.

Stoneridge, Inc. SRI: Michigan-based Stoneridge designs and manufactures engineered electrical and electronic components, modules, as well as systems. Over the past 60 days, its fiscal 2020 loss estimates have widened by 40 cents a share. The company currently carries a Zacks Rank #4.

Mercer International Inc. MERC: Mercer owns and operates a diverse pulp and paper business. The firm manufactures bleached softwood kraft pulp that is used in tissues, hygiene products, and high-end printing and writing paper. Over the past 60 days, fiscal 2020 loss estimates for this Zacks Rank #4 firm have widened by 22 cents a share.

Bottomline Technologies, Inc. EPAY: New Hampshire-based Bottomline Technologies provides collaborative payment, invoice, and document automation solutions to corporations, financial institutions, as well as banks on a worldwide basis. Over the past 60 days, 2020 earnings estimates for this Zacks Rank #4 company have moved from $1.21 per share to $1.16. The metric depicts a year-over-year decline of 14.1%.

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