The market for supplying LED technology to tablets and flat screens has been a particularly frothy sector this year, with analysts having spent the year in a constant EPS upgrade cycle. Cree Inc. (CREE.O) is a beneficiary of this trend, but is also being battered by rough competition.
Cree makes lighting products, LED components and semiconductor products for power and radio-frequency (RF) applications. “Green” consumer lighting solutions have been igniting Cree’s growth and investor enthusiasm but are also causing lower margins. In addition, increased competition in the LED sector has stalled Cree’s growth story. The stock closed down 22.3% on August 14. Even after that correction, the stock remains up an impressive 120% over the last 12 months, versus 20% for the S&P 500.
Source: Eikon
Trading on enthusiasm
As any student of financial history knows – whenever market euphoria carries stocks to extended valuations, the likelihood of disappointment increases, either at the individual stock level or in aggregate. There’s nothing new here; “The Madness of Crowds” was published in 1841.
The Eikon view below clearly highlights the characteristics of these stocks that have moved from sensible optimism into euphoria –the stock detaches from its valuation and trades on enthusiasm and momentum. The valuation models highlight extreme caution while earnings upgrades and price momentum drive the stock. Such an approach may be lucrative for the nimble trader, but is far more risky for a buy and hold investor.
Source: Eikon
Strong outlook, rough competition
For those who own the stock from lower levels, clearly its prospects remain strong, but competition in the sector remains fierce, with the chart below highlighting the steady downward drift of margins. Moreover, the challenge is to understand what level of growth is already priced into the stock – today, that’s a compound annual growth rate of 22.4%. By comparison, the trailing five year annual growth rate is a negative 9.4 %.
Source: Eikon
Good company vs. good investment
Cree is a good company, well positioned to benefit from the underlying technology shift towards LED. However, there’s a difference between a good company and a good investment. The traditional stock market cycle carries companies through pessimism, scepticism, optimism and euphoria and there’s not much doubt where much of the market sits today.
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