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Pricey Stocks in Pricey Sectors

Investors need to be more focused than ever on security selection as valuations between sectors continue to diverge.

This is a tricky time to be an investor. Equities look slightly overvalued, meaning there is hardly a plethora of undervalued, high-quality names in which to invest. At the same time, the alternatives to stocks aren't looking so hot either. Although there is a case to be made that holding an above-average amount of cash makes sense right now, low yields ensure that holding only cash isn't a winning proposition. And the fixed-income market looks unlikely to produce large returns in the face of a rising-rate environment. Right now, it is more important than ever to focus on security selection, steer clear of the most expensive parts of the market, and stick to your long-term asset-allocation strategy. 

Security selection is becoming ever more important as valuations diverge across sectors. Overall, of the equities under Morningstar analyst coverage, the median stock is trading for 4% more than the analysts' estimate of intrinsic value. But some areas (such as technology and consumer cyclical) are trading 10% or more over our fair value estimates. These sectors are priced for perfection and then some. Investors receive no margin of safety if the broader economy doesn't live up to expectations or if there is some other unforeseen shock. Avoiding the priciest stocks in the most overvalued parts of the market can help create a portfolio that is better-positioned if market turmoil occurs down the road.

 Median Price/Fair Value by Sector
 Technology 1.11
 Consumer Cyclical 1.10
 Consumer Defensive
 Health Care 1.07
 Utilities 1.06
 Industrials 1.06
 Financial Services
 Real Estate 1.00
 Communication Services
 Basic Materials 0.88
Source: Morningstar

Full valuations don't mean that it is time to completely abandon stocks, however. For investors with long-enough time frames, it still makes sense to have an appropriate allocation to equities. But if you do have to pay a full price for stocks, it almost always makes sense to stick to high-quality companies. Firms with sustainable competitive advantages, or economic moats, are not immune from economic trends and broad-based stock market sell-offs. However, they do have the power to keep earning economic profits for years to come and are likely to turn in better fundamental performances over time. These characteristics can make them solid long-term holdings. 

It is much harder to justify paying well more than fair value for no-moat businesses that are less likely to produce solid earnings streams over time. Avoiding overvalued, no-moat names can go a long way in creating a sturdy portfolio that will withstand changing market conditions. 

We used Morningstar's  Premium Stock Screener to find stocks that investors should avoid right now. We screened for firms that have Morningstar Ratings for stocks of 1 or 2 stars, that are in on the three most overvalued sectors, and that have no moat. You can run the screen for  yourself here. Below are three firms that passed. 

 Caesars Entertainment       
| Fair Value Uncertainty Rating: Very High      
From the  Premium Analyst Report:
Caesars Entertainment is the largest domestic casino company, operating more than 30 casinos in the U.S. market. The company lacks an economic moat because of the proliferation of casino licenses in the United States, which has led to low returns on invested capital. We've assigned a fair value uncertainty rating of very high given the company's overleveraged balance sheet, the result of a leveraged buyout completed in 2008, the cyclicality of the U.S. casino industry, intensifying competition, and the company's high fixed costs, which amplify the impact of an economic downturn on results.

 Church & Dwight (CHD)     
| Fair Value Uncertainty Rating: Medium      
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 fierce actions from its competitors to reclaim market share and ultimately stall its progress) that we believe could persist over the long term.

 Advanced Micro Devices (AMD)   
| Fair Value Uncertainty: Very High  
From the  Premium Analyst Report:
Advanced Micro Devices faces some long-term competitive obstacles against  Intel (INTC) in the microprocessor market. The recent weakness in the global PC market has put pressure on demand for the firm's processors. The PC processor industry has long been dominated by Intel, the world's largest semiconductor company. As the underdog, AMD historically managed to maintain a minor share in the market by providing a low-cost alternative to Intel's higher-performance chips. AMD has periodically shown some flashes of brilliance, as in 2003-06, when it took the lead in processor performance and gave Intel a run for its money. Riding on the strength of its Opteron server processors, AMD took significant share from its rival and added PC makers such as  Dell  to its list of customers. But the success was only temporary; AMD has since lost its processor performance crown to a resurgent Intel and has been struggling to keep up.

All data as of Aug. 2. 

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