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Beware These Wall Street Darlings

Wall Street likes these stocks. We don't.

Morningstar currently rates about 60 stocks as 1 star, meaning we think they're at least 30% overvalued. Among these companies, you'll find quite a few that Wall Street loves, at least judging by the number of "strong buy" ratings they receive.

There's a common reason for the disagreement, aside from the fact that "strong buys" still flow like tap water on Wall Street: While Wall Street focuses on earnings, we focus on stock valuation. Here's what I mean by that (admittedly gross) generalization. If a company's profits are rising, chances are Wall Street analysts will recommend the stock. They cherish companies that meet quarterly earnings targets, for example, and will often judge a management team largely on the basis of whether it can meet those quarterly targets. If it doesn't, then the management team "loses credibility." And if the company misses its targets and the stock is in free fall, eventually it's sure to attract a lot of "hold" ratings. 

But when everything's going well, stocks tend to become expensive. And that's where the discrepancy between Wall Street recommendations and Morningstar's star ratings often arises. When we run some of these stocks through our discounted-cash-flow (DCF) models, we get fair values way below the current stock prices. That's why they receive low star ratings. The companies may be great. But the stocks aren't.

I ran a screen in  Premium Stock Selector for stocks with high Wall Street ratings but Morningstar star ratings of 1 or 2 stars. Eight of these stocks appear below. For most of these eight companies, profits and sales are up. They've beaten consensus estimates over the past year. The so-called "news flow" is good. As a result, they have a good number of "strong buy" ratings from Wall Street. But we think the stocks have gotten ahead of the businesses. Based on our assumptions about future growth rates and cash flows--which are less rosy than those of Wall Street--they'd be sells in our book, not buys. (FLWS)
Wall Street: 3 Strong Buys, 2 Moderate Buys
Morningstar: " Assuming that its revenue keeps growing in the 15%-18% range and that its operating margin eventually improves to double digits, we think the stock is worth around $12….This could be one of a handful of e-commerce stocks worth owning--if the price were to come down a bit."  Full Analyst Report

Wall Street: 5 Strong Buys, 3 Buys
Morningstar: "At its current valuation, we think the stock is a pretty risky investment, particularly in light of Continental's dour near-term prospects and its difficult financial position. We would avoid it."  Full Analyst Report

Wall Street: 6 Strong Buys, 5 Buys, and 2 Holds
Morningstar: "Harley has glided right over the economic speed bump, but the market remains too optimistic about the company's continued success and is pricing the shares well above our fair value."  Full Analyst Report

Home Depot (HD)
Wall Street: 12 Strong Buys, 9 Buys, and 2 Holds
Morningstar: "We're still afraid of Home Depot stock at its current price."  Full Analyst Report

Kraft Foods (KFT)
Wall Street: 8 Strong Buys, 4 Buys, and 2 Holds
Morningstar: "Kraft Foods has been an island of stability amid the economic jitters roiling the markets. Even so, we don't think its growth prospects quite justify its price."  Full Analyst Report

Laboratory Corp of America (LH)
Wall Street: 11 Strong Buys, 7 Buys, and 1 Hold
Morningstar: "We project sales to increase an average of 9.5% over the next five years and operating margins to steadily improve to 22%, up from 17% in 2001. But with the shares currently trading in the $90s, we'd hold off buying until the price drops."  Full Analyst Report

Marvell Technology (MRVL)
Wall Street: 5 Strong Buys, 4 Buys, and 1 Hold
Morningstar: "Even with the firm's strong revenue growth, we think the stock will prove a poor investment….It's not as if our DCF assumptions are conservative, either."  Full Analyst Report

Quest Diagnostics (DGX)
Wall Street: 9 Strong Buys, 8 Buys, and 2 Holds
Morningstar: "…Even with bullish numbers in our model, our fair value of $78 per share (up from $55) comes up short of the current stock price."  Full Analyst Report

More Reading
"Buying Stocks Wall Street Hates", by Haywood Kelly

"Don't Pay Too Much for Your Stocks", by Pat Dorsey

"Home Depot Has Wall Street Feeling Lucky", by Pat Dorsey

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