Built for Destruction

 | Jan 14, 2013 | 2:30 PM EST
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As much as I enjoy searching the dark corners of the market for stocks to buy regardless of conditions, it is just as important to identify stocks to avoid. This is especially true now, when there are still substantial market obstacles ahead. I do not think earnings season is going to be particularly robust, and the debt ceiling will no doubt create political fiascos and comedies. Even more disconcerting, mutual fund inflows hit the highest level since 2001, and hedge fund leverage is the highest in four years. This type of buying after the 9% move since mid-November is a little scary for a natural contrarian like me.

I am not saying to run out and sell all your stocks. I have never done that and I base my decisions to sell a stock on fundamentals, not market moves. There are sectors and stocks, however, that should be avoided as the valuation and business prospects imply substantial risk no matter what the market does this year.

Avoid homebuilders and anything associated with the building trade. Residential real estate markets are improving slowly but these stocks discount a recovery back to 2007 levels. Stocks such as Ryland (RYL), PulteGroup (PHM) and Standard Pacific (SPF) have doubled over the past year and it's time to exit or avoid the group. All three stocks trade at substantial premiums to tangible book value, and that is a recipe for potential disaster. Everyone loves them again, and institutions own most of the shares of all three. Even if the market rallies this year, these stocks will not see fundamental improvements that justify the current valuation and price. If there's a decline in general stock prices, homebuilders will lead the way lower.

This is going to carry over to companies that sell to homebuilders. Sherwin-Williams (SHW) has seen its stock rise by more than 70% in the past year based on housing optimism. The company is the leader in paints and coatings and has made several smart acquisitions in the past few years to bolster its position. In November it spent more than $2 billion to buy a privately held Mexican paint and coating company that will broaden exposure into the Latin American markets. The company is doing a lot of things right but it is more than reflected in the stock price. The price-to-earnings ratio is now the highest in a decade and the housing recovery is not robust enough to justify this valuation. Even if the company hits the earnings estimate from Wall Street, the shares are at 80% of the highest PE ratio reached between 2011 and 2012. This is a very good company but at this level, it is not a good stock for long-term investors.

The same applies to Home Depot (HD).Slight improvements in the housing market have driven the stock price higher by almost 50% in the past year. I avoid home-improvement projects like the plague but handy friends tell me Home Depot is still the chain of choice for building supplies and do-it-yourself projects. It is a very good company, but the stock price is double the 2007 price levels and it should not be. The stock trades at the high end of the last 10 years' valuation and I do not think the housing recovery, or the consumer, has recovered enough to justify the pricing.

Lowe's (LOW) has not had as a dramatic run-up in price but I believe it will share the fate of other building-related stocks. These stocks are all partying like its 2006 -- and that simply is not the case. Housing is still struggling to recover fully and there is enough distressed inventory to make homebuilding a risky business. Housing is better than it was, but it is still not good yet. We are probably nearly two years away from clearing distressed and foreclosed inventory to the point that building can normalize.

I have no idea what the stock market will do today, next week, or for the balance of 2013. I do know that the fundamentals do not justify the valuations of builders and related stocks, and they will probably be laggards in a rally. If we do get a serious decline in the broader market indices, these issues will lead the charge to the bottom. The key to thriving as an investor is surviving, and avoiding these stocks can help achieve that goal in 2013.

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