Don't Buy These 10 Stocks!

With the S&P 500 up about 12% and the Nasdaq up more than 23% this year, many investors have decided it's safe to jump back into the pool. Human nature being what it is, the majority of investors naturally will sell stocks when the market is going down, and do the opposite when the market is going up. Although this is a recipe for poor long-term returns, it's also a fact of life.

If we accept the fact that people put more money into the market when they feel "safe," and that they feel safe when stocks are going up, then we can draw another conclusion: Many investors feel safe putting money into high-risk stocks because they tend to rise the fastest when the market bounces. When this happens, the herd mentality feeds on itself, gains beget gains, and the result is a momentum-inspired frenzy of exuberance that lasts until, without warning, the momentum stops and the dumb money is left without a chair.

Bad Bets
This scenario is especially common for companies with no economic moat; when the momentum stops, their shares can pull back violently. To find some stocks that might be prone to a big pullback after a momentum-inspired rally, I ran a screen on Morningstar.com and specifically looked for those that met the following four criteria:

1. No economic moat
2. Year-to-date returns greater than 75%
3. Have been publicly traded for at least five years
4. Have a star rating assigned to them

My screen brought up 10 stocks, listed in the table below. None of the 10 has an economic moat, and--although I didn't specifically screen for this--each one is rated 1-star by our analysts.

10 Stocks to Avoid
	Fair Value Estimate ( $ )	Current Price ( $ )	Price/FV Ratio	YTD Return ( % )	2002 Return ( % )	5-Year Return* ( % )
Scientific-Atlanta	14.00	28.31	2.02	138	-50	19
Ameritrade	6.00	9.95	1.66	77	-4	26
PMC-Sierra	5.00	10.68	2.14	87	-74	2.5
Nortel Networks	1.80	2.91	1.62	80	-79	-25
Veritas Software	20.00	29.88	1.49	86	-65	19
Ericsson	5.00	13.70	2.74	108	-87	-25
Alcatel (ALA)	5.50	9.89	1.80	119	-73	-23
Computer Assoc.	10.00	24.35	2.44	79	-61	-8
E*Trade Group (ET)	5.00	8.60	1.72	76	-53	4
Sears Roebuck	31.00	41.49	1.34	76	-49	-1
Averages			1.90	93	-59	4.91
S&P 500			1.06	12	-22	-1
* Annualized Data as of 08-08-03

We can draw a few conclusions from this data. First, these stocks are wildly overvalued according to Morningstar analyst estimates. On average, they sell for 90% above our fair value estimates, meaning they would have to decline by about 48% to get to fair value.

If you make the assumption that Morningstar's 40 analysts are, on average, as good as the market at predicting long-term cash flows, then these stocks' prices seem to be completely divorced from their intrinsic values. Even if you assume that our analysts are a bunch of loons, it seems virtually inconceivable that they're 90% off, on average, on a group of 10 stocks. Any way you look at it, the 10 no-moat stocks that have done the best this year represent a very bad risk/reward tradeoff at current prices, compared with their future cash-flow generating ability.

When the Best Are the Worst
Now take a look at the group's 2002 returns. On average, they returned -59%, with none of them showing a positive return last year. Obviously, these stocks do very poorly in a bear market. Investors who buy these stocks are essentially making a bet that we're at the beginning of a new, sustained bull market, and they're not worried about the downside risk. That's a pretty big bet to make. If the market pulls back, these stocks will get hammered if they follow the same pattern as in 2002.

And then there are the five-year returns. Despite bouncing up an average of 93% so far in 2003, the five-year trailing return of the 10-stock portfolio is just 4.9%. While that seems pretty good compared with the S&P 500 return of -1%, there's some heavy survivorship bias here. I screened for stocks that Morningstar covers that have been around for at least five years. This ruled out many no-moat companies that were around five years ago but are now bankrupt or delisted. Hundreds of now-defunct Internet companies fall into this category.

It seems likely that over the next five years, at least a couple of these 10 no-moat companies will disappear. The average three-year return on equity of the 10 stocks is
-16%. Unless they can dramatically turn things around and start realizing positive returns on equity, some of them will run out of capital and won't be able to access the capital markets.

In other words, as a group, the 10 no-moat stocks on our coverage list that have done the best this year are probably the worst candidates for long-term investors.

Roll the Bones
Now, there are a few possibilities I haven't considered: Maybe the future will turn out to be better than the past for these companies. Maybe they've turned things around, and, even if a couple of them go under, as a group they'll do well over the coming five years. Or maybe a couple of these companies will thrive, and maybe you can predict which ones and avoid the others. Maybe our fair value estimates are way off. Maybe these stocks will continue to go up for a while longer, and you can sell right near the top and get out.

All of these things are possible, but, of course, none of them is probable. Investing is a game of probabilities--three parts art, two parts science, and an occasional pinch of luck. If you consistently spread your bets across high-probability situations--what I call "fat pitches"--the math says that you will, over time, do pretty well. If you consistently invest in low-probability situations, the math says the opposite. It's akin to playing blackjack in Vegas--the odds are stacked against you ever so slightly, and the more games you play, the greater your chances of coming out behind. In fact, one could define gambling as consistently making bets in which the odds are against you. By contrast, good investors consistently make bets in which the odds are in their favor.

Warren Buffett says he rarely, if ever, invests in a stock while it's going up. Bill Miller invests when the situation looks ugly to everyone else. Both make a living buying stocks when everyone else is selling them. So if you buy any of the 10 stocks above, consider this: You're not only betting that you can outsmart the market, you're betting that you're smarter than two of the greatest stock market investors ever. Sounds like a gamble to me.