The Market's Most Overvalued Stocks

Peter Lynch's classic advice to "buy what you know" can be a good starting point for amateur investors--you're much more likely to understand a business if you regularly use its products. For example, a doctor who treats diabetics is likely to know more about  Novo Nordisk's (NVO) insulin products than the average investor and have an edge in assessing Novo's prospects. Even with hours of research, the same doctor is unlikely to have nearly as much insight on tech firm  Cisco (CSCO) or insurance giant  AIG (AIG).

Even so, Lynch's advice is probably among the most abused in investing, as it is often interpreted to mean "buy the stock of your favorite consumer products company without doing any more research than sampling the product." Skimping on research is always a bad idea--even if you're sure a product will be a hit, there's no guarantee the company that makes it will be a good investment. Worst of all, well-known brands often lead to overpriced stocks, as other satisfied consumers transfer their enthusiasm to the markets.

Two footwear examples from the recent past are  Heelys  and  Crocs (CROX), whose charts are below. A year ago, you could hardly walk down the street without seeing a kid in Heelys sneakers with wheels or a bright pair of Crocs. Today, the stocks are even less fashionable than the shoes.

HLYS chart

CROX chart

In this article, we offer a twist on Lynch's advice: Sell what you know. Following are three well-known consumer brands whose stocks we consider significantly overvalued.

 Hanesbrands (HBI)
Recent Price: $31.94
Price/Fair Value Estimate: 1.60
Hanesbrands owns some of the most recognized brands in apparel and undergarments, including Hanes, Champion, Playtex, and L'eggs. We believe the business faces sizable challenges. As a result of its 2006 spin-off from  Sara Lee , the company has $2.32 billion of long-term debt, the interest payments on which eat up almost half of operating income. Its core markets are saturated and mature, leaving little room for growth. A commoditized product and powerful customers like  Wal-Mart (WMT), which accounted for 27% of 2007 sales, pressure prices and restrict its ability to pass on rising commodity costs. Finally, Hanesbrands continues to manufacture its own products, which is a costly, capital-intensive proposition.

 Revlon 
Recent Price: $0.82
Price/Fair Value Estimate:1.64
Revlon is one of the best-known brands in beauty care. However, the company is teetering on the edge of bankruptcy, with negative shareholder's equity and about $1.4 billion in debt. Revlon hasn't turned a profit in 10 years, failing to generate enough operating income to cover interest expense. Its market share is slowly dwindling in the face of a growing number of competitors in the beauty care aisle, and the company lacks the resources to match the marketing and research and development budgets of industry giants like  Proctor & Gamble (PG). The only thing keeping Revlon above water appears to be the financial support of its chairman, Ronald Perelman, who controls 100% of the company's B shares and 58% of the A shares.

 Jetblue Airways (JBLU)
Recent Price: $3.67
Price/Fair Value Estimate: 2.04
Jetblue has one of the best reputations for customer service among airlines, thanks to comfortable seats, in-flight entertainment, and free snacks and beverages. Alas, airlines have made for some of the worst long-run investments in history--a trend that seems unlikely to reverse. Strapped consumers, the weak economy, and rabid competition are restraining Jetblue's ability to raise prices at the same time that fuel and other costs are soaring. The company's fleet will require growing levels of maintenance capital as it ages, and its workforce will require higher compensation as it accumulates tenure. A heavy debt load and a large sunk investment in planes make Jetblue's financial health precarious.

Morningstar Analysts Michelle Chang and Marisa E. Thompson also contributed to this article.

Stock prices as of market close on June 11, 2008.