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Stock Strategist

The Market's Most Overvalued Stocks

Large caps are cheap--but we'd avoid several at current prices.

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In our previous article on the market's most overvalued stocks, we targeted companies that remained overvalued despite being down significantly for the year. Recently though, stocks have rebounded. To honor the Dow Jones Industrial Average for recently surpassing its all-time high, we'll play the contrarian and highlight some overvalued stocks in our large-cap coverage universe.

First, a little background. On the whole, large-cap stocks remain cheap. We've noticed for quite some time that the large-cap portion of our 1,900-stock coverage universe has consistently traded at a larger discount to our fair value estimates than the small-cap portion. Although this gap has narrowed somewhat with large caps outperforming small caps by 4% (11% versus 7%) year to date, the discrepancy remains.

Still, this does not mean that all large-cap stocks are good buys today. In fact, 18% of the 500 large caps covered by our analyst staff are trading above our 1-star (Consider Selling) price, while only 8% are trading below our 5-star (Consider Buying) price. (To see which companies fit these molds today,  click here for the 1-star stock screen  and here for the 5-star stock screen.)

What's the Appropriate Strategy?
Passive investors may be well-served by investing in a hassle-free, large-cap exchange-traded fund, but our staff of 100 equity analysts are stock pickers at heart, and this strategy won't do. We'd rather make concentrated bets on the winners instead of letting the stocks we know to be overvalued drag on our returns. Yes, this strategy takes more time to implement and monitor; however, for the active investor, we think the greater potential reward is worth the extra effort.

Below is a list of companies that represents a sampling of large-cap stocks to keep out of your portfolio for the time being, followed by a brief excerpt from the Analyst Reports. Nearly every sector was represented in the 1-star large-cap stock screen, so I picked one company from a few different industries. As a reminder, a 1-star rating does not necessarily mean our analyst dislikes the underlying company, it simply means that the market has more optimistic expectations than our discounted-cash flow models can justify.

Seven Stocks to Sell

Schlumberger (SLB)
Industry: Oil & Gas Services
Premium to Fair Value Estimate: 150%
From the  Analyst Report: "As with all oil-service companies, Schlumberger could face difficult times if oil and gas prices had a significant and sustained fall. Its reliance on technology and acquisitions to drive revenues could backfire if a competitor developed better technology, or if an acquisition failed to perform up to expectations. The company's extensive infrastructure in Russia could prove to be a liability if Russia decides to treat service companies like it has treated operators, such as Yukos."

Bunge (BG)
Industry: Food Manufacturing
Premium to Fair Value Estimate: 85%
From the  Analyst Report: "Despite its impressive growth and global scale, Bunge's unattractive position as a middleman means the company has little control over the pricing of the products it buys and sells. Profitability can swing wildly on changes in crop yields, commodity prices, and currency exchange rates, leaving this agribusiness company with no economic moat." In addition, Bunge was recently highlighted in a different stock strategist article that cited this firm's poor earnings quality.

TD Ameritrade Holdings  (AMTD)
Industry: Securities
Premium to Fair Value Estimate: 70%
From the  Analyst Report: "Online brokerage is an ultra-competitive industry where variable costs are almost nil. While the industry has consolidated, new players with lower price points continue to enter the market. TD Ameritrade benefits from scale, but this has not been sufficient to dissuade potential competitors, particularly large banks that offer free trades as a loss leader. Early data suggests competitors' free trades have not made a meaningful impact on TD Ameritrade's customer base, but it is difficult to imagine that the firm will be able to maintain its current pricing in the long term."

Celgene Corporation  (CELG)
Industry: Biotechnology
Premium to Fair Value Estimate: 60%
From the  Analyst Report: "Celgene sells thalidomide, which is known to have caused thousands of birth defects. Although the company maintains a patented compliance and patient-education program, there is a risk that toxicity could hurt the sales potential of the related, newly approved drug Revlimid as well as other thalidomide derivatives in development. With much of Celgene's future revenue tied to Revlimid, any regulatory or safety roadblocks could spell disaster for the shares."

Loews Corporation (LTR)
Industry: Insurance
Premium to Fair Value Estimate: 45%
From the  Analyst Report: "An 89% interest in commercial insurer CNA Financial (CNA) accounts for about 53% of Loews' equity, 57% of its revenue, and close to 100% of its moat deficiency. CNA's asbestos liabilities are large and uncertain, which increases the risk that Loews' cash will be used to keep CNA solvent. CNA frequently incurs underwriting losses, and its average return on equity is far below its cost of equity. CNA has been on the mend for more than a decade, and we don't anticipate substantial improvement. What's worse, Loews' management has given no indication of plans to excise this cancer."

AT&T, Inc.  (T)
Industry: Telecommunications Services
Premium to Fair Value Estimate: 40%
From the  Analyst Report: "Growing competition from cable companies and wireless substitution threaten to reduce profitability in the local phone business, which is one of AT&T's main sources of cash flow. Competition in high-speed Internet access and wireless is also stiff, and the firm may not be able to earn a decent return on its investments in these areas."

Sun Microsystems, Inc. (JAVA)
Industry: Computer Equipment
Premium to Fair Value Estimate: 30%
From the  Analyst Report: "We believe Sun will be challenged by its lack of sustainable competitive advantages. Sun's share of the worldwide server market declined from 11.6% to 9.5% between 2003 and 2005, according to industry researcher IDC. While Sun recovered a bit in 2006 on the strength of new products, we believe its long-term competitive position is weak. IBM and Hewlett-Packard (HPQ) offer comparable server platforms on the high end, but with superior service organizations that help companies design, deploy, and maintain their technology infrastructure investments."

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