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The Most Dangerous Small-Cap Stock On The Market

Michael Vodicka

The market is flashing big warning signals right now.

The biggest concern is the Federal Reserve tapering its quantitative easing program. The impact of the world's most powerful central bank reducing the size of its monthly bond purchases cannot be overstated. An official announcement on tapering will most likely have a huge effect on the market.

Second-quarter earnings also came in weak, with headliners like Microsoft (Nasdaq: MSFT) and Wal-Mart (NYSE: WMT) falling short of expectations and voicing weak forecasts.

That fundamental weakness went on to trigger multiple sightings of the Hindenburg Omen, considered one of the most bearish technical indicators in the market with a strong history of predicting pullbacks and corrections.

Any of these events on their own would be worrisome and good enough for a weak patch in the market. But all three together, while the market trades with a relatively high valuation near the all-time high, has investors on edge.

If the market falls, overvalued small-cap stocks will be the most vulnerable. And there is one stock from this group that will be particularly vulnerable to losses in a broad sell-off. 

This company has cashed in on the popularity of real estate as an asset class in the past 10 years and went public two years ago. Shares had been mostly flat before skyrocketing to a new all-time high and 195% gain this year

I'm talking about Zillow (Nasdaq: Z), the popular online real-estate services specialist. 

While those are solid gains for Zillow investors, that bullish move on the chart hasn't been matched by earnings or earnings growth projections. In fact, Zillow has no earnings at all -- in fact, the company is expected to lose 63 cents a share this year and 3 cents in 2014. Although that's big-time progress toward achieving profitability, it makes Zillow's $85 share price one of the most overvalued in the market and vulnerable to a sharp decline on any weakness in the S&P 500.

But it's not just potential weakness on the chart that Zillow investors should worry about. The company is also suffering from the high cost of growth. Zillow plans to double its spending on sales and marketing in 2013, jumping to $100 million. That $100 million investment is expected to increase revenue 60% to management's projected $187 million in 2013. 

If the cost of increased sales comes at the expense of margin strength, then the scalability the company is banking on to become profitable is at risk. Those diminishing marginal benefits are the same problems that took Groupon's (Nasdaq: GRPN) shares from $25 at its initial public offering to $2.69 before rebounding recently.

Zillow will also be battling a highly fragmented and regional market, intense competition and an industry with very few barriers to entrance. This sounds like the antithesis of the Warren Buffett investment philosophy , which is to invest in market leaders in established industries with high barriers to entrance that limit new competition.

Risks to Consider: Zillow continues to see impressive growth in online traffic and premium subscription rates. Although earnings still remain negative, the company is expected to become profitable in 2015. Zillow is also one of the hottest momentum stocks on the Street, which means it can trade with high valuations for extended periods of time.

Action to Take --> The market has been flashing warnings signals, with the Fed taper and Hindenburg Omen fueling fear of a sell-off on the Street. That would weigh on all segments of the market, but overvalued small caps will be hit the hardest. And Zillow is one of the most overvalued small caps in the market. Although Zillow continues to see impressive sales growth, the company is years away from turning a profit. And with shares trading near a fresh all-time high, there's still time to take profit and avoid a stock that is particularly vulnerable to a broad sell-off.

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