After suffering a 6.5% correction between May 22^nd and June 24^th, the small-cap Russell 2000 index (^RUT) broke to a new all-time intraday high on July 8^th and has kept on rising. All the investor worry about the Federal Reserve beginning to taper its quantitative-easing bond purchases has proven unfounded, especially for small caps. The reason, as I outlined in the May 22^nd Roadrunner Stocks  article entitled QE Tapering May Be Good for Small Caps, is that the Fed will only begin QE tapering if economic growth is strengthening and small caps benefit the most from stronger economic growth. Through July 15^th, the Russell 2000 has outperformed the S&P 500 by more than a four-percentage-point margin — 23.7% to 19.3%.

Since May 22^nd, the large-cap S&P 500 index has lagged behind the Russell 2000, but managed an all-time closing high on July 11^th (intraday all-time high has yet to be exceeded). Because small-caps often lead the market, it is only a matter of time before the S&P 500 also hits a new all-time intraday high. Regardless, the biggest future gains are likely to be in the small-cap space because that’s where the strong earnings growth will be. In mid-June at the Morningstar Investment Conference, fund manager Richard Bernstein — who used to work at Merrill Lynch as its chief investment strategist – explained why U.S. small caps are the equity style of choice for the foreseeable future despite seemingly-high price-to-earnings (P/E) ratios:

Post 2000, bull markets have generally begun with higher P/Es, and the P/Es have shrunk as the cycle has matured because you had a more cyclical rebound in earnings. Therefore, the time to sell more cyclical, lower-quality, smaller-cap stocks will be when the P/Es are very low. In other words, that will be peak earnings.

U.S. small-cap stocks have projected earnings growth right now that’s twice the projected earnings-growth rate of the emerging markets. I don’t think people realize that. The reason that you are seeing such high valuations on small-/mid-cap stocks in the United States is because the market is beginning to anticipate that earnings growth coming. So, you can see why we’re so bullish on small-/mid-cap stocks and not put off by the valuations.

Large-caps are more international and receive a substantial portion of their sales in foreign currency. With the U.S. economy strengthening, the U.S. dollar is appreciating which makes the foreign sales of these large-cap companies less valuable in U.S. dollar terms. In contrast, U.S. small caps are focused on the domestic economy and benefit fully from a stronger U.S. economy without experiencing the earnings headwinds of dollar strengthening and foreign-exchange depreciation.

Although the future of fundamentally-strong small-cap stocks is exceeding bright with a strengthening economy, the Fed’s easy-money policy has also fueled a stock-market melt-up that has raised all boats, even those that don’t deserve it. The silly-season of rampant speculation has boosted stock prices of companies with exciting stories but weak fundamentals. The poster children of this speculative frenzy are video distributer Netflix (Nasdaq: NFLX) and electric car manufacturer Tesla Motors (Nasdaq: TSLA).

Netflix

Netflix has been one of my least favorite stocks for years, primarily because it has no competitive advantage and simply is an easily replaceable middle-man between video content producers and the consuming product. The stock crashed from $304 in July 2011 to $53 a year later. In October 2011 I wrote that the stock would be a buy at $59.50 or lower and it has since roared back in a breathtaking round-trip that has the stock trading at $257. This past April – with the stock trading at $216 – Chad Fraser quoted me saying that the stock has enough positive price momentum that it could get up to the $250 level before stalling. With the stock having reached my momentum-based $250 price target, it’s a definite short.

The stock has had three weeks of huge upward thrusts during 2013, each one on successively lower trading volume:

Source: Bloomberg

Since the end of 2011 when its one-time-only sweetheart distribution deals with video content providers expired, the financial performance of Netflix has fallen off a cliff and is nothing short of disastrous:

Source: Bloomberg

So, why has the stock risen 175% so far in 2013 given such unimpressive financial results? The answer is that investors are speculating that recent video content distribution deals with Disney, Warner Brothers, and DreamWorks Animation – along with original programming House of Cards, Hemlock Grove, and Arrested Development — will boost earnings later.  Never mind that these deals simply replace other video content that has been stripped from the Netflix video library. Competition is heating up with Redbox Instant (a joint venture between Outerwall and Verizon), Amazon Instant Video, and Apple TV. A few original programs notwithstanding, Netflix is essentially a middle man squeezed between increasing video-content input costs and retail prices under heavy pressure from competition.

Investing based on pure speculation – combined with focusing on good news and ignoring bad news — is the sure road to the poorhouse. Profitless growth is worthless and investors in Netflix will find that out sooner rather than later. The only thing going for Netflix is that CEO Reed Hastings is a founder CEO, but he doesn’t own much of the company anymore and even a great manager with a commitment to a company’s long-term success cannot win against deteriorating business fundamentals.

Tesla Motors

Everybody is rooting for an electric-car company to succeed because electricity power is fueled by plentiful U.S.-produced natural gas, which reduces dangerous dependence on foreign oil and possibly is good for the environment as well. But a good idea for society does not translate into profitable venture. Just ask Israeli electric-car company Better Place, which went bankrupt earlier this year, or China’s BYD Co., which experienced a collapse in profits over the past four years.

Simply put, electric cars are a money-losing business. Fiat CEO Sergei Marcchione estimated earlier this year that the company loses $10,000 on each electric car it sells – even after accounting for government subsidies. Investors have been bidding up the price of Tesla stock on the hopes that it will be able to ramp up production to mass-market levels, but Marcchione says that mass-marketing electric cars is “masochism at its extreme.”

It is true that Tesla generated its first quarterly profit in history recently, but this was due entirely to California zero emission vehicle (ZEV) credits and federal greenhouse gas emission credits – both of which have nothing to do with the real supply and demand economics of manufacturing and selling electric cars. Without government subsidies, the company would have lost $91 million in Q1 2013. In other words, earnings quality was horrible and cannot be sustained. Even worse, during the Q1 conference call CEO Elon Musk said that first-quarter ZEV credits are the peak for the year:

We’re expecting a decline in the credit revenue for Q2 and then probably fairly significant decline in Q3 and as I said back right now, we’re not expecting anything in Q4.

The result is that Tesla will return to reporting quarterly losses for the remaining three quarters of 2013. As the following table demonstrates, reporting losses is the normal state of affairs for Tesla since its June 29, 2010 IPO:

Source: Bloomberg

Tesla was added to the Nasdaq-100 index on Monday, July 15th. History shows that stocks added to stock indices subsequently underperform the stocks that were deleted. Right on cue, Goldman Sachs downgraded Tesla on July 16^th — the day after the index addition – and the stock fell 14.3%. (I swear that I started writing this negative article on Tesla before the Goldman downgrade).

As with Netflix, Tesla is run by a founder CEO. Unlike the Netflix CEO, however, Tesla Motors CEO Elon Musk owns a very-substantial 24.5% of the company’s stock, having recently purchased an additional 1.08 million shares at a price of $92.25 as part of Tesla’s May 30^th secondary offering. Musk borrowed $150 million to make the stock purchase, however, so if the stock falls and he suffers a margin call, his forced selling could further exacerbate a stock price decline. An example of such a detrimental margin call occurred with Chesapeake Energy’s former CEO Aubrey McClendon in 2008.

Bottom line: Tesla has spent all of its bullets keeping its stock afloat in 2013. Government subsidies are diminishing for the remainder of the year and the hype over the Nasdaq-100 index inclusion is over. When the company reports second-quarter earnings the week of July 22^nd and investors see the return of bottom-line losses, you can stick a fork in Tesla because its upward thrust for 2013 is coming to an end.

Roadrunner Safety Rating Very Low on Both Netflix and Tesla Motors

As further confirmation that neither Netflix nor Tesla is a good investment right now, I analyzed both stocks according to Roadrunner Stocks’ six-point safety rating system. Netflix scored an abysmally-low “1” and Tesla was only marginally better at a still low “2” rating:

Netflix and Tesla Motors: Overvalued and Unsafe Stocks

The key to successful investing is separating the winners from the losers, the high-risk from the low risk. If you can avoid “the big loss,” profits will take care of themselves. According to my Roadrunner safety-rating system, avoiding high-risk companies like Netflix and Tesla is a good first step in protecting your equity portfolio and ensuring that good stocks are given the chance to generate wealth without being neutralized by bad stocks.