The Market's Most Overvalued Stocks

In our previous article on the market's most overvalued stocks, we focused on expensive real estate stocks, mostly real estate investment trusts and other financial-services firms. Hopefully some of you were able to push the sell button in time, because it's been a rough couple of months in that space.

For this installment, we focus on overvalued, low-quality and risky stocks that have outperformed the market (the S&P 500 in this case). We define low-quality companies as those which Morningstar analysts have deemed "no-moat"; that is, they likely don't earn their cost of capital through an economic cycle, usually because they lack sustainable competitive advantages. We define risky companies as having a wide spectrum of potential outcomes, making it more difficult to determine the proper valuation of their stocks.

Here are the other parameters to this screen. To avoid borderline overvalued stocks, we looked for companies that were trading at greater than 1.4 times our fair value estimates. We eliminated foreign stocks to reduce extraneous variables and set the minimum market capitalization to $3 billion to appeal to a wider group of investors. Finally, we excluded companies in the air transport industry. This decision wasn't for a lack of candidates--airlines dominated the results of this screen prior to being excluded. However, in a recent stock strategist article (High Oil Prices Pack a Double Whammy for These Airlines) one of my colleagues, Marisa Thompson, already did a great job of highlighting some of the pressures this industry faces.

Below are snippets taken from the Analyst Reports for four firms I chose from the screen, spelling out the downside risks. For a more well-rounded perspective, we highly recommend reading each report in its entirety.

Four Overvalued Stocks

CF Industries Holdings, Inc. (CF)
Industry: Chemicals
Price to Fair Value Estimate: 229%
From the  Analyst Report: "While the near-term outlook is certainly bright for CF, we have serious concerns regarding the sustainability of current market conditions. First, the tremendous profits being reaped by domestic producers are sure to attract additional supply to this market, which has fairly low barriers to entry. Also, natural-gas costs are a looming concern, because they can represent between 60% to 80% of the firm's total costs. Any shift in what has been a relatively benign cost environment since Katrina could quickly send profits tumbling. Finally, any decline in international shipping rates could quickly increase the attractiveness of imported product and force domestic producers to reduce their operating rates."

Warner Chilcott Limited 
Industry: Drugs
Price to Fair Value Estimate: 146%
From the  Analyst Report: "Warner Chilcott is subject to near-term generic competition, as six of its top eight products will lose patent protection in the next four years. The company no longer promotes women's health products femhrt, Estrostep, or Sarafem, each of which loses patent protection by 2010.  Barr  launched a generic version of oral contraceptive Ovcon 35 in 2006. The company plans to extend the life of dermatology products Dovonex and Doryx through new formulations or marketing. However, some sales will be lost as antibiotic Doryx offers no patent protection, and the patents for Dovonex lotion and ointment expire in 2007."

Shaw Group 
Industry: Metal Products
Price to Fair Value Estimate: 145%
From the  Analyst Report: "Despite its attractive growth opportunities, Shaw remains highly susceptible to the cyclicality that plagues its end markets. The company has been able to generate shareholder value during market upturns. Yet more often than not, the working-capital intensity of the engineering and construction business has prevented Shaw from earning a return in excess of its cost of capital. This recurring trend illustrates the difficulty the firm has encountered in trying to create long-term shareholder value."

Invitrogen Corporation 
Industry: Biotechnology
Price to Fair Value Estimate: 142%
From the  Analyst Report: "...Invitrogen operates without an economic moat and competes with other firms selling a large number of similar products. For instance,  Qiagen (QGEN), Applied Biosystems, a unit of  Applera , and Invitrogen all sell kits to amplify DNA, which gives each firm little opportunity to raise prices. In addition, there are almost no barriers to entry in the industry and startup firms routinely develop new technologies that challenge existing ones. As a result, Invitrogen must constantly innovate to keep its product-line fresh and differentiated. However, even if Invitrogen develops a technological advantage, it will likely prove short-lived, as competitors with equal or greater resources spend heavily to catch up."