tech stocks

8 pricey stocks haunting the Nasdaq

April 11, 2014: 3:52 PM ET

Problem underscores a glaring weakness in cap-weighted indexes

FORTUNE -- The Nasdaq boosters can't be kept down: The recent selloff, they insist, is a frenzied overreaction that's serving up even better buys. On April 10, the Nasdaq composite index fell 130 points, or 3.1%, marking its largest one-day loss since Nov. 9, 2011, when it fell 3.9%.

The sharp re-pricing is well-deserved. Over time the Nasdaq will careen through spikes and valleys as usual, but the overall trajectory should be downward. In fact, the big losers in the sudden rout are precisely the stocks that grew into the most extravagantly expensive corner of the index. That group, more than any other, made the Nasdaq soar. Now it's a millstone.

The wildly overpriced stocks fall into two main areas, social networking and biotech. Let's examine the fantastic run experienced by eight companies in those categories. They're mostly the ones with the highest market caps: In social networking, the group comprises Facebook (FB), Google (GOOG), and Baidu (BID) of China; the biotech players are Alexion (ALXN), Gilead (GILD), Celgene (CELG), Biogen (BIIB), and Amgen (AMGN).

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At the start of 2013, the total value of those eight stocks stood at around $570 billion, accounting for 18% of the Nasdaq 100's aggregate market cap of $3.1 trillion. (The Nasdaq 100 consists of the 100 largest companies in the overall index, ranked by market cap.)

Since then, the Nasdaq has gone on a tear, rising by 39% by April 8, the day before the selloff. But the combined value of the eight high-flyers jumped by more than 80%, more than double the overall gain in the index. Alexion rose 66%, Celgene 88%, Gilead 92%, Biogen 104%, and Facebook 122%. Only Amgen -- it gained a relatively modest 40% -- failed to beat the market by a wide margin.

By April 8, the value of those eight stocks had swelled from 18% of the Nasdaq 100's total market cap to almost one-quarter, an increase of over 6 percentage points.

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And they became really, really expensive. The price-to-earnings ratios grew to 97 at Facebook and 113 at Alexion. The only company with a multiple below 28 (the number for Google) was Amgen at 17.

Over their past four quarters, the eight companies have posted combined earnings of $28 billion, vs. a combined market value of more than $1 trillion. Hence, the group, taken as a whole, is selling at 37 times profits.

If investors seek an 8% annual return from holding these volatile stocks, these companies will need a growth spurt in earnings of 15% annually for eight years, so that their profits would triple over that period. It's unlikely to happen.

The Nasdaq problem underscores a glaring weakness in cap-weighted indexes. As the prices of our eight sprinters outraced the rest of the index, a bigger and bigger share of an investor's holdings shifted to the most expensive stocks. If you kept adding money to a Nasdaq fund over that period, you were simply buying increasing portions of the overpriced stuff with every purchase.

That's the opposite of a Warren Buffett-style value strategy. Nasdaq investors are now stuck with far too much money in pricey shares that are cruisin' for a bruisin'. This crazy market is finally making a turn that makes perfect sense.

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