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Commentary

No Margin of Safety in These Stocks

The runup in stock prices has all but erased the margin for error in many parts of the market.

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Although volatility has remained, the market have been on a roll recently. The S&P 500 this week reclaimed the 1,400 level it hadn't seen since May. Since the start of the year, the broad Morningstar U.S. Market Index is up nearly 13%, and up more than 20% over the last 12 months. The runup in the market has lifted valuation levels and all but erased the margin of safety in most corners of the market. And some areas are beginning to look downright expensive.

So what's driving stocks upward? The market seems to be relieved that the global economy has so far avoided any number of bad outcomes. Despite some close calls, the euro remains intact. Mario Draghi's pledge to protect the euro no matter what has, at least in the short term, calmed investor fears. The U.S. economy continues to bump along. And China's government is doing a decent job of easing off the gas pedal without sending the economy into a downward spiral.

But despite any short-term relief, these recent gains are tenuous and could very well end up being ethereal. Europe remains teetering on the brink, the U.S. still has a serious employment crisis and a broken political process, and China could still very well slide toward a hard economic landing.

Given the huge amount of uncertainty in the world, we've long advocated that stock investors look for deep discounts to intrinsic value before committing to a security. That way if the economy does take a turn for the worse, you have a margin of safety to protect your investment; everything doesn't have to go exactly right in order to come out ahead. 

^INX Chart

^INX data by YCharts

On the flip side, if you spend too much for a stock, you could easily be left holding the bag if one of the downside risks hits the economy. Broadly speaking, the market as a whole doesn't look unreasonably priced, according to our staff of equity analysts. Their price to fair value for the entire market stands at 0.93, not exactly a screaming bargain but not hugely overvalued, either. But certainly some sectors are beginning to look a bit frothy.

It's no big surprise that the three sectors historically seen as good income generators--real estate, consumer defensive, and utilities--are the most overvalued. With yields on traditional fixed-income investments in the basement, investors have been clamoring for equities that pay reasonable dividends. This demand has bid up the prices for these equities, and pushed valuations higher. Certainly not every stock in these sectors is overvalued, but on average these sectors are not fertile hunting ground for bargain-seekers.

Within these sectors, some stocks stand out as particularly pricey. Not only do investors not get a reasonable margin of safety on these names, they are actually paying a hefty premium to our fair value estimates. Based on Morningstar's analysis, investors in these names not only have no protection if something unexpectedly goes wrong, but they are also betting that almost everything that can go right will. Even if these shares have a decent current yield, your total return may not look too good over the long run if these shares drop closer to their intrinsic value over time.

To uncover these overvalued stocks, we used Morningstar's Premium Stock Screener to find 1- and 2-star rated equities in the real estate, consumer defensive, and utilities sectors. Below are three names that passed the screen. You can run the screen for yourself by clicking here.

 Douglas Emmett (DEI) 
Price/Fair Value: 1.57 | Fair Value Uncertainty: High | One-Year Return: +36%
From the Premium Analyst Report:
Douglas Emmett is a REIT that invests mainly in office properties in Los Angeles County and Honolulu, Hawaii, with some exposure to multifamily properties in these markets as well. We do not see evidence of an economic moat in its financial results, and given its regional concentration and exposure to small- and medium-sized businesses, we believe there is a high degree of uncertainty around our fair value estimate.

 Great Plains Energy (GXP)
Price/Fair Value: 1.38 | Fair Value Uncertainty: Low | One-Year Return: +26%
From the Premium Analyst Report:
Following the sale of Strategic Energy and purchase of Aquila in 2008, Great Plains Energy has transitioned from a diversified energy services company into a fully regulated electric utility. This shift to increased regulated returns has reinforced the company's narrow economic moat. With the conclusion of KCP&L's Comprehensive Energy Plan in 2010 and rate case decisions in 2011, earnings visibility has significantly increased. However, we expect continued regulatory lag, limited rate base growth, and lagging electricity usage to challenge returns and earnings.

 Church & Dwight Company (CHD)
Price/Fair Value: 1.23 | Fair Value Uncertainty: Medium | One-Year Return: +30%
From the Premium Analyst Report:
Church & Dwight's efforts to drive down costs and invest in marketing support and product innovation have resulted in improving sales and profitability. While we acknowledge the firm's recent success, we aren't convinced that these results are sustainable, given the impending challenges (particularly related to fierce actions from its competitors in an effort to stall its progress) that we believe could persist over the long term.

All data as of Aug. 10, 2012

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