No Shortage of Pricey Stocks Today

This was a very unusual week for the markets. After the devastation of Hurricane Sandy, the stock exchanges shut down for two days, coming back on line Wednesday as much of the Northeast was still in the early stages of recovery from the storm. Then there was the flurry of economic data from October, including the final jobs report before the election. Add in more third-quarter earnings reports and some surprising merger and acquisition news and the market had plenty to mull over. But despite all this news, stocks ended the week about where they started.

With no big changes in share prices (or in our analyst's reckoning of what stocks are worth), valuations remain very full. The median price/fair value ratio of Morningstar's coverage universe stands at 0.96. The price/fair value ratio of the individual sectors ranges from 1.06 for real estate to 0.88 for energy. Last week we explored how in this market investors needed to carefully consider stock selection before diving into the market. But just as important as looking for very cheap stocks to invest in, is avoiding pricey stocks.

Given the continued overvaluation in several areas of the market, these expensive stocks aren't a scarce commodity. About one fifth of our overage universe now has a Morningstar Rating for stocks of 1 or 2 stars. These overvalued names, particularly the ones without long-term competitive advantages or moats, are likely to be among the hardest-hit equities in the event of a market correction.

And the possibility of a correction remains very real. The most likely culprit this year seems to be the fiscal cliff. We've already heard from a few management teams through this earnings season that they are beginning to get very worried about the upcoming mix of tax hikes and spending cuts. What was once a distant prospect has become a very real possibility. By Tuesday night, we will likely know who will lead in Washington for the coming years, but it does seem very unlikely that one party will control both houses of Congress and the White House. No one is going to emerge with a clear mandate. That means a tricky negotiation will need to take place during the lame-duck session. It would appear that the most likely scenario here would be kicking the can down the road a few months (which only delays the uncertainty more), while the worst case could be that the economy falls off the entire cliff. There just isn't much prospect for a so-called grand bargain that will put the country on a long-term sustainable fiscal path.

There are of course other potential roadblocks. Europe's problems are far from solved, and the world is still trying to adapt to slowing growth in China. These potential issues don't mean you should avoid the market altogether, but it does point to the importance of having a good margin of safety between what you think a stock could be worth and what it is trading for before you purchase it. To find stocks that investors should avoid putting in their portfolios, we used Morningstar's  Premium Stock Screener tool to find no-moat companies with low star ratings. You can run the screen for yourself  here. Below are three names that passed.

 Gap (GPS)      
Fair Value Uncertainty Rating: Medium | YTD Return: +89%    
From the  Premium Analyst Report: 
Gap is one of the longest-operating specialty retail stores in the U.S., offering affordable fashion in basic apparel for a broad audience. By appealing to a multitude of customers, the company grew to become the largest specialty apparel retailer domestically. However, increased competition from newer specialty retail chains, along with some merchandising missteps, eroded Gap's once strong economic moat and pressured the firm's revenue growth in recent years. Additionally, we remain concerned that as retailing has become more global, Gap has had to compete against international firms like Inditex, which can provide updated fashion at a faster pace because of a more vertically integrated business model. The specialty retailing space is fragmented with few barriers to entry, which yields Gap no economic moat. Going forward, the company stands to benefit from improving productivity thanks to a reduction in weak performing stores, growth in global locations, and most important, a revamped merchandising strategy. We note that unemployment rates remain higher than historical averages and an uncertain global economic outlook exists, which could be recognized as headwinds that may temper near-term demand and make Gap's transformation take longer than anticipated.

 Plum Creek Timber       
Fair Value Uncertainty Rating: High | YTD Return: +18%        
From the  Premium Analyst Report:     
With only a small manufacturing business to speak of, Plum Creek's value unquestionably resides in its timberland holdings, which comprise 6.6 million acres throughout the U.S. Judged solely by log harvest profits, Plum Creek's timberland isn't especially valuable. We estimate the company's holdings generated average EBITDA of $37 per acre from 2004 to 2011, quite a bit lower than our estimates for timber REIT peers  Rayonier (RYN) ($55 per acre) and  Weyerhaeuser (WY) ($80 per acre). Geographical distinctions account for the differences among the three. In Plum Creek's case, an "overweight" position in the less productive tree-growing regions of the country explains its lower "per acre" profits.

 Nomura Holdings (NMR)         
Fair Value Uncertainty Rating: Very High | YTD Return: +22%           
From the  Premium Analyst Report:     
Nomura was one of the world's leading investment banks in the 1980s, but a series of missteps left the company in limbo for much of the next two decades. The company retrenched with massive equity raises as a result of the global financial crisis, and now--under a relatively new CEO in Kenichi Watanabe--is attempting to slowly regain its earlier stature. While some moves--like the company's bargain acquisition of Lehman Brothers' Asian and European operations--are beginning to pay off, we believe Nomura faces a long road ahead as it attempts to match the performance of its remaining global peers, such as  Goldman Sachs (GS). 

All data as of Nov. 2.