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Stock Strategist

These Stocks Could Lay an Egg

Keep these equities out of your basket.

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On Easter morning, plenty of investors will be filling baskets with chocolate eggs and prepping for an enormous brunch. But hopefully they won't follow up brunch by grabbing a bunch of stocks that will likely lay an egg in their brokerage statements.

Although there are still pockets of opportunity left in stocks, the tremendous rally during the last year has left many stocks looking more than fully valued. There are currently 58 stocks that hold a 1-star, Consider Selling, rating and another 317 rated 2 stars. The list ranges from firms whose values have disintegrated (such as mortgage giant  FannieMae (FNM)) to solid businesses whose stock prices have run away from the fundamentals of the business (such as (CRM)).

Does it make sense to short all of these stocks? No. The short-term price movements of stocks are uncertain, at best, and you could get stuck with carrying and other costs that could negate the gains from shorting. But in the long run, we think that investors won't be well served in these stocks.

Here are a few 1-star stocks. See the entire list for yourself  here using our  Premium Stock Screener.

 Netflix (NFLX)
Moat: None | Fair Value Uncertainty: High | Price/Fair Value Ratio: 2.11
From the  Analyst Report:
Netflix has attracted millions of subscribers and remains the leading player in the market for DVD rental by mail. We think the company's value proposition, loyal user base, and strong brand will lead to solid growth during the next couple years. However, we don't think the company is well positioned for the long run, as digital distribution of content has lower barriers to entry and will likely lead to new competitive threats.

We applaud the company's efforts in attempting to avert suffering the same fate as store-based rental services: a gradual decline in market share, customers, and profitability. However, even though it's difficult to know exactly how the market will shake out, we think Netflix's lack of competitive advantage in digital delivery will eventually strain subscriber growth and will pressure profit margins because of higher content costs and increased marketing expenses.

 W.W. Grainger (GWW)
Moat: Narrow | Fair Value Uncertainty: Low | Price/Fair Value Ratio: 1.40
From the  Analyst Report:
W.W. Grainger distributes industrial supplies such as motors, tools, fasteners, and safety gear for maintenance and repair operations. We believe the firm's established, extensive scale, wide product range, superb delivery times, and localized product offerings afford a narrow economic moat, which will enable Grainger to deliver an excellent return on invested capital for years to come.

We have some concern about the cyclicality of the business. Grainger's sales growth is highly correlated with the total manufacturing output of the United States, and that tends to be hugely cyclical. In times of downturn, we expect Grainger's operating profits to fall faster than sales because of operating leverage. However, we think the firm's efforts to increase its product range and expand its store footprint will moderate recessionary effects. (PCLN)
Moat: None | Fair Value Uncertainty: Medium | Price/Fair Value Ratio: 1.48
From the  Analyst Report: offers a commodity product in a price-competitive industry. Although scale in the online travel market can lead to network effects, Priceline is not the largest competitor, and, as a result, it has no economic moat.

There is a medium level of uncertainty surrounding Priceline's future results because of the deteriorating consumer-spending environment. However, we think international growth opportunities should allow the company to become more profitable as long as it can maintain its pricing power in the tough competitive environment that will come with new entrants and a more mature market.

Moat: None | Fair Value Uncertainty: High | Price/Fair Value Ratio: 2.00
From the  Analyst Report:
The slow evolution of the enterprise storage market has enabled upstarts such as 3PAR to capitalize on new trends before established vendors react. However, despite 3PAR's early success, the industry giants are responding quickly, and we believe it will be challenging for the firm to generate long-term economic returns.

Despite impressive growth and a compelling technology, we are concerned the company will ultimately be lost in the shuffle. 3PAR still only claims less than 1% of the networked storage market, and rapid growth must come at the expense of established and well-funded competitors. We believe the capacity and manageability benefits of 3PAR's storage solutions will secure a niche for years to come, but the explosive growth could be fleeting without further innovation to differentiate its products.

All data as of April 1, 2010.

Jeremy Glaser does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.