Adding to the Avoidance List

 | Oct 04, 2012 | 2:00 PM EDT  | Comments
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Stock quotes in this article:

tol

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phm

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pnw

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por

Before I move on to more interesting and exciting topics like playoff baseball and the Florida-LSU game this weekend, I want to spend a little more time on avoidance. There are some stocks and sectors that I believe should be avoided by long-term investors right now.  Many sectors have seen a strong rebound this year and the stocks are no longer safe or cheap. Buying them exposes you to the possibility of stating a permanent loss of capital if the price declines to reflect worsening fundamentals and a more reasonable valuation. The key to success in the markets for individual investors is to survive.  If we focus on safe and cheap while avoiding the over-loved and overvalued, we ensure our survival and the upside will take care of itself.

One group that really stands out is the homebuilders. I suggested buying this group at the end of last year when it was the worst-performing sector in the market. Today, it is one of the best-performing sectors on a year-to-date basis. Investors are anticipating a recovery in the building market and have been aggressive buyers of the builders. Toll Brothers (TOL) has seen its stock price rise by almost 70% over the past year. PulteGroup (PHM) has soared by more than 150% over the same period. If you were lucky enough to catch the ride from ugly duckling to darling, it is time to take some money off the table. If you missed the move, resist the urge to chase these stocks no matter how many bullish research reports you may read.

There have seen signs that the real estate markets are stabilizing. Prices have firmed in some markets and we have seen a slight uptick in home sales in some areas of the country. Housing starts have risen sharply and many of the builders will show a profit for the first time in several years.  In spite of these positives, the group is not a buy. The stock prices reflect this small upturn in housing and discount a boom that I don't believe will materialize. The truth is that the economy and jobs drive housing, not the other way around. We need to see strong job growth and a recovering economy before the homebuilders are a growth industry again. If Roger Arnold is correct about bank-owned real estate inventory, we could see a flood of homes come on the market next year and put a brake on new building activity.

These stocks are not cheap. I have always done well buying builders when they were wildly unpopular and traded at a discount to book value. Right now, very few meet this criterion. PulteGroup trades at more than 3x book value. Toll Brothers is at 260% of its asset value. All of the forward price-to-earnings ratios are in the high teens and virtually every building stock has a price-to-sales ratio above 1. Even if I thought building would remain robust throughout 2013, the stocks are not cheap enough to offer either a margin of safety or potential long-term adequate return.

I am also cautious on the electric utility industry at the current level. I love utility stocks and any time I can buy them below book value I am enthusiastic. When markets collapsed in 2008, I was an enthusiastic buyer of Pinnacle West (PNW), Portland General (POR) and other utility companies at less than tangible book value. They have provided a very nice total return, but yield-chasing by starved income investors has pushed the stocks well above a reasonable valuation. It is time to consider selling your overpriced utility stocks and waiting for them to be unlived once again in the future. It is definitely not the time to buy these stocks, no matter how attractive the dividend may appear in a zero-interest-rate world.

Success in a market rally is a question of survival much of the time. Buying when stocks are safe and cheap is critical for long-term success. So is avoiding the temptation to buy the hot popular groups everyone loves. No matter how sexy the story of renewed housing strength lifting builders is, or how a recovering economy and low natural gas is lifting utility shares, valuation still matters. These two groups are just too rich for long-term investors to buy now.

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