Should You Say Goodbye to Hot Stocks?

As Sir John Templeton famously said, the best time to buy is the time of maximum pessimism, and the time of maximum optimism is the best time to sell. Thanks to the market's stunning runup over the past several months, we're arguably closer to the optimistic side. That means it's prudent to take a hard look at your equity holdings. If you own stocks that have been riding a wave of market optimism, it makes sense to think about paring them back to make room for holdings with more appreciation potential.

For this week's Five-Star Investor, we used Morningstar's  Premium Stock Screener to identify stocks trading at inflated valuations. (Premium Stock Screener is included in Morningstar.com Premium Membership. If you're not a Premium Member, click here to sign up for a free trial.) We started out by screening for stocks that are trading within 10% of their five-year highs. There are more of those names out there than you might expect: Almost 20% of the 7,196 stocks in Morningstar's equity database met this criterion.

The fact that a stock is near the high end of its historical range doesn't necessarily mean it's overvalued, though. The higher price could simply reflect continued growth in earnings and free cash flows. So we added an additional screen, focusing on stocks that are currently trading at least 20% higher than Morningstar's estimate of their fair value. (Our fair value estimates are based on discounted cash-flow models.) Finally, because we're willing to cut a stock more slack on price if the company has a strong competitive advantage, we eliminated firms with wide economic moats.  

Many of the names that made the final cut are cyclical stocks such as Caterpillar and Danaher, which investors have bid up in the nascent economic recovery. A number of tech and biotech names also showed up thanks to this year's big runup in Nasdaq stocks. 

One last note: The final decision to sell depends on several different factors, including your specific tax situation. If you've held a stock for many years and have built up significant capital gains, you may want to consider selling over a period of several years to minimize the gain in a particular year.

 Caterpillar (CAT)
Stock Price as of Sept. 10: $67.55
Fair Value Estimate: $50
Business Risk: Average
Economic Moat: Narrow
From the  Analyst Report: "Caterpillar's June quarter was excellent. We've raised our fair value estimate to reflect stronger-than-expected demand and progress on cost reduction. Despite the increase, however, Cat stock still looks overvalued to us."

 Gilead Sciences (GILD)
Stock Price as of Sept. 10: $66.74
Fair Value Estimate: $33
Business Risk: Above Average
Economic Moat: Narrow
From the  Analyst Report: "Gilead Sciences has finally turned the corner to profitability. It has had several product wins over the past two years and has built a reputation for successfully developing anti-infective drugs. Its recent acquisition should help boost short-term sales growth. We would like the stock at the right price, but that price would have to provide a big discount to our fair value estimate to compensate investors for the firm's long-term product-development risks."

 Deere & Company (DE)
Stock Price as of Sept. 10: $53.07
Fair Value Estimate: $45
Business Risk: Average
Economic Moat: Narrow
From the  Analyst Report: "We've raised our estimate of Deere's fair value to $45 per share from $38 to reflect better-than-expected growth and an adjustment in our treatment of the firm's underfunded pension plan. However, the stock would have to fall considerably before we'd be interested."

 Electronic Arts (ERTS)
Stock Price as of Sept. 10: $88.55
Fair Value Estimate: $65
Business Risk: Average
Economic Moat: Narrow
From the  Analyst Report: "We think Electronic Arts has substantial and sustainable competitive advantages, and we'd love to own the stock at the right price. The company has a great deal of valuable intellectual property. It doesn't depend on suppliers. Also, a lack of customer concentration and any true "substitute goods" (thanks to the strength of EA's franchises) make for very little pricing pressure."

 Danaher (DHR)
Stock Price as of Sept. 10: $75.27
Fair Value Estimate: $62
Business Risk: Average
Economic Moat: Narrow
From the  Analyst Report: "Danaher stock has had a strong runup in the past two months, as the U.S. economy has begun to show signs of recovery. The recovery has not yet manifested itself in Danaher's operating results, however. Although revenue rose 16% in the first half of the year, all of the gain came from acquisitions and currency effects; revenue from existing businesses shrank 1.5%."

To run this screen yourself and see all the stocks that passed, click  here. (The stocks mentioned above passed our screen as of Sept. 10. The results of the screen may change due to daily price fluctuations or other factors.) After clicking, you can save the search to use later by clicking the "Save Criteria" button in the bottom right-hand corner of the screen. (Note: You will need to be a Premium Member to view and save the complete screen.)