Big Stocks Are Carrying Big Price Tags

 | Mar 04, 2014 | 2:30 PM EST
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I know that I come across as a curmudgeonly skeptic when it comes to the markets, especially these days. I consider it my role in life to be aware of the risk and to study what can go wrong.

If I buy stocks right, the upside will take care of itself, so I do not see the need to spend much time considering the potential good stuff. The combination of value and time will take care of that. I am better off considering what could possibly go wrong and use this information to enhance my margin of safety.

However, if you think I am a grumpy curmudgeon when it comes to stocks, wait until you hear what Seth Klarman of Baupost Funds has to say right now.

I haven't been able to obtain a full copy of the legendary value investor's letter yet, but excerpts and quotes are hitting the Internet. In the excerpts I have read, Klarman acknowledges that there is a bull case for those who never met a stock they did not love. He is quoted as writing, "Price-earnings ratios, while elevated, are not in the stratosphere. Deficits are shrinking at the federal and state levels. The consumer balance sheet is on the mend. U.S. housing is recovering, and in some markets, prices have surpassed the prior peak. The nation is on the road to energy independence. With bonds yielding so little, equities appear to be the only game in town."

He then goes on to outline what he sees in the markets right now. "If you're more focused on downside than upside, if you're more interested in return of capital than return on capital, if you have any sense of market history, then there's more than enough to be concerned about." He cites bubbles forming in certain stocks such as Netflix (NFLX) and Tesla Motors (TSLA), as well as junk-bond issuance, yields and credit quality.

I could go on in this vein, quoting from the letter, but that work has already been done, and anyone who has a decent search engine can find excerpts. I can add more value by talking about what areas investors and traders need to avoid, lest they become caught up in a changing market that destroys capital. Even if the bulls are right, why would you want to own stocks that are overpriced and which could well underperform, even the most booming of bull markets?

This morning, I ran a simple screen. I looked at the more popular and well-known stocks in the S&P 500. I Used the Graham number calculation as a rough estimate of intrinsic value, to see which stocks might be overvalued or undervalued right now. I found that 186 of the stocks in the index traded at twice their intrinsic value, and 297 of the index companies traded at more than the calculated value of the company.

The list of wildly overvalued companies includes popular blue-chip stocks such as Coca-Cola (KO), Merck (MRK), Disney (DIS) and McDonald's (MCD). No matter which way the market goes, it is unlikely that these overpriced, great companies will lead the market higher or resist a plunging bear market.

Just 42 stocks trade for less than their intrinsic value, as derived by the Graham number. The list is dominated by energy and financial companies. Just 22 of these undervalued companies have Piotroski F-scores of 6 or higher, which indicate the type of financial and fundamental improvements that lead to higher stock prices in the future. Only six of these trade at the 70% or less of intrinsic value and could potentially be considered bargain issues with upside potential. For those keeping score at home, the six are Citigroup (C), Hess (HES), Edison International (EIX), Unum (UNM), Pulte (PHM) and Rowan (RDC). Of those, only Rowan has any interest to me at current prices and discount-to-book-value level.

I do not know if Klarman will be justified for his cautious view of the markets. I am not really willing to be against him, as his track record as an investor stands for itself. I do know that if he is cautious, I do not want to own a portfolio of stocks that are overvalued to the extremes and possess the potential for permanent losses. There is not a lot of value in the stocks that make up the major indices, and that in and of itself is a cause for concern. Most of these stocks are best avoided by all but the most adept and nimble traders.



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