3 Overvalued Quality Stocks

Investors have no shortage of worries on their minds right now. Will the U.S. economic recovery get derailed by the fiscal cliff? Or problems in Europe? Will a slowing China put pressure everywhere? Will the Federal Reserve's new bond-buying program work or just stoke inflation? 

This uncertain world can be unsettling, but it doesn't mean that investors need to be unreasonably fearful or abandon their asset allocations. We've long advocated that equity investors would be well-served by buying firms with great competitive advantages, or economic moats. That's still good advice today, but with stocks hitting multiyear highs, investors need to keep valuations firmly in mind before diving into the market.

Extra Protection
Having the structural ability to fend off competitors and earn an outsized return on capital is always a good sign for a firm, but moats are even more valuable right now. Look at inflation for example. One of the big fears of the Fed's unprecedented expansion of its balance sheet is that long-term inflation is going to creep higher. We're not talking about hyperinflation where we will be buying bread with a wheelbarrow full of cash. Instead we might see prices rising at, say, 3% or 4% a year from today's much lower levels. In a low-return environment, that change could have a big impact.

Firms with moats can offer some protection here. Because of their competitive advantages, these companies have better pricing power and should be able to insulate themselves somewhat from higher prices by passing them on to customers. Now of course no one can raise prices indefinitely, but firms with moats have a much better shot of keeping up with inflation than companies that are forced to worry about competitors swooping in if they try to raise prices.

But it is not just pricing power. Financial and business stability are important, too. By and large, firms with moats have stronger balance sheets, are less dependent on short-term financing, and have more durable businesses than no-moat companies. In the event of a major problem in Europe or another banking crisis, these companies can more likely withstand the storm. That isn't to say that firms with moats won't get beat up during a crisis (look to 2008 to see that they will), but quality firms are less likely to have their businesses permanently impaired than lower-quality firms.

Be Sure to Eye Price
Moats might be great, but paying any price for them isn't. Plunking down $200 for a $100 bill isn't going to work out very well for anyone. But finding that $100 bill for $50 is getting harder and harder. The recent runup in the market has left stocks roughly fairly valued, and screaming bargains are now few and far between. Many stocks with moats have even become meaningfully overvalued. Investors who ignore valuation do so at their own peril. Take wide-moat stock performance for example. If you bought all wide-moat stocks in an equal-weighted index, you would have returned an average of 5.2% a year. If instead you invested in the Wide-Moat Focus index, which holds only the cheapest 20 wide-moat stocks and rebalances quarterly, your five-year return would have been 9.2%. 

This is all the more reason to keep a close watch on stock price before buying, regardless of a firm's competitive advantages. To find quality companies that are overvalued right now, and thus worth waiting for a lower price, we used Morningstar's  Premium Stock Screener to find narrow- and wide-moat names with Morningstar Ratings for stocks of 1 star. You can run the screen for yourself by
 clicking here. Below are three stocks that passed.

 DirecTV 
Economic Moat: Narrow | Fair Value Uncertainty Raring: Medium        
From the  Premium Analyst Report:
DirecTV has continued to take share in the U.S. television business, most recently using its NFL Sunday Ticket platform to lure customers. On the flip side, margins have come under pressure as content costs continue to rise faster than revenue. We believe this cost pressure will remain an issue for the foreseeable future as consumers' options for television service expand. At the same time, DirecTV's Latin American business has hit its stride recently. Economic strength in the region has provided a nice tailwind, but DirecTV has also taken market share. The firm has shown that it can compete well in Latin America, but we expect many of the longer-term issues it faces in the U.S. will eventually pop up in this market as well.

 Intuitive Surgical (ISRG)
Economic Moat: Wide | Fair Value Uncertainty Raring: Medium       
From the  Premium Analyst Report:
Intuitive Surgical looks set to continue expanding in its niche of robotics-assisted minimally invasive surgery by targeting new procedures within several surgical specialties. Through its large installed base and first-mover advantages, we think Intuitive has developed a wide economic moat that should keep returns on invested capital high even if direct competitors arise in the future.

 Verisk Analytics (VRSK)
Economic Moat: Wide | Fair Value Uncertainty Raring: Medium       
From the  Premium Analyst Report:
Verisk is one of the insurance industry's leading risk specialists. Its comprehensive solutions enhance its clients' ability to manage insurance programs and claims processing. The company has an attractive business model with high revenue visibility, significant barriers to entry, high switching costs, and a scalable operating model. These factors have helped the company create a wide economic moat around its operations, in our view.

Even if these three firms look overvalued right now, investors can still find some good names trading at decent prices. Firms with moats like  Alcoa ,  Johnson Controls (JCI), and  Exelon (EXC) are all trading at big discounts to their intrinsic value.

Data as of Sept. 21.