Margin of Safety Is the Best Answer

 | Apr 03, 2013 | 1:00 PM EDT  | Comments
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Stock quotes in this article:

lux

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fbhs

An annoying question I hear every day is: "What do you think of the market here? What do you think the stock market is going to do this week, month or year?"

Whether intellectual or financial, speculation on what one thinks the market may do is one of the least productive and dangerous activities in which investors can engaged. I see the same talking heads and pundits that everyone else sees. I hear the oft-repeated sensible reasons the market should go up or down. I think it is a ridiculous way to burn brain cells.

I have no clue what will happen in the stock market. If I were forced to do so, I would say that after the run we have had without a meaningful correction, we should be due for a pullback. I would not waste a dime of my money or anyone else's money betting on my opinion. That is also the majority opinion right now, so it is even more likely than usual to be wrong.

I will react to what the market does. I try to keep my interaction with the stock market averages to buying when they are down and taking profits when they run up and my stocks become fully or overvalued. Anything else is just rank speculation of little real value to investors.

After a good rally, I will look around for stocks that have appreciated and are now overvalued as measured by earnings, cash flow and asset value. I do not know if these will go down or up in the near term. I do know that owning them after a strong move up exposes investors to a real risk of a loss of capital if the stocks miss earnings or otherwise fall out of favor.

When I have a high conviction about an overvaluation I may even take a little of what I euphemistically call my trading account and establish a chicken short. Sometimes they work, sometimes they do not. The most important take away from the exercise is to avoid stocks that could become a disaster no matter what the market does.

While watching the Baltimore Orioles begin their dominance of the American League East, I ran my screens for overvalued stocks that I feel have too much risk for most long-term investors. These are often good companies about which investors have become too enthusiastic. Such is the case with Luxottica (LUX), the eyeglass manufacturer. The company's eyeglasses are in most of the major retailers and many ophthalmologists offices as well. The market the always popular Oakley and ray ban lines of sunglasses. Sales and earnings growth has been solid as they are the dominant player in the market place.

However, the stock is up 23% already this year and more than 40% over the past 12 months. The stock fetches 35 times earnings and 25x the always optimistic analyst estimates for 2013. The stock trades at more than 4x book value and 2.7x sales. The enterprise value/earnings before interest, taxes, depreciation and amortization ratio is over 14 well above any rational level in my opinion. If the stock were to fall back and trade at the average price/earnings ratio of the last decade, it would quickly shed a third of its value. The company has not surprised anyone with earnings coming in within the range of estimates for the past four quarters. If they fall short, this stock could cause a lot of pain.

It is no secret that I am skeptical about the strength of the housing recovery. A lot of the buying appears to be by institutions accumulating rental housing and not individuals buying a home for their family. For that reason, I am not sure that Fortune Home Brands (FBHS) deserves the 50 P/E multiple it sports. The company makes cabinets, plumbing material and accessories, windows and security systems. It is a pretty good company and operating results have been improving handsomely.

So has the stock price with a one-year gain of 60% and a 22% gain so for in 2013. The stock is at 2.5x book value and the EV/EBITDA ratio is a stratospheric 21. The analysts have been raising estimates aggressively so they haven't been surprising anyone and a quarterly miss could send the shares tumbling.

Both of these companies have a solid business. It appears the stock prices have gotten ahead of the business prospects, however, and there is an elevated chance of a permanent loss of capital. I have no idea what the stock market might do, but I do not want to get caught owning stocks whose price offers no margin of safety if it should decline sometime this year.

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