Over-Loved Stocks That Don't Stack Up

 | Oct 31, 2012 | 3:23 PM EDT
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Today we will try to get back to business as usual in the markets. The earnings reports will begin to dominate the news once again. The bulls will look for any positive sign to be buyers as we head into year-end, and the bears will celebrate any signs of weakness. I will simply sit back and apply my usual sense of cynicism to the whole show.

I confess that at this point I am most cynical about the bull case for the market. Earnings are following the same revenue-light pattern with lowered guidance that we have seen all year. The economy is still solidly in "better but not good" mode, and Europe is still a mess. The only real bullish case relies on low interest rates, and as powerful as that has been, I am not sure it is enough to keep moving the market higher.

My opinion on market direction does not matter that much, as I am not a trader, and I evaluate stocks on a case-by-case basis. Once I was done updating my files on infrastructure and banking this week, I spent some time playing around with Piotroski F-scores, which use a set of nine fundamental criteria to help investors gauge a firm's financial position. F-scores have been found to be very predictive of future stock price movements when combined with valuation, and in the past few days I have used them in several ways to uncover opportunities. My cynical side also led me to use F-scores to find some stocks that investors should avoid right now because of low scores and high valuations.

When using Piotroski F-scores, one thing I found interesting was how many of the market's growth darlings actually have a Piotroski score of 5, which is the line in the sand for using F-scores. A score above 5 indicates potential outperformance, and below that level is negative. A score of 5 indicates that a stock is just a lukewarm market-tracking stock, according to my research. Stocks that score a 5 but have been over-loved include Chipotle Mexican Grill (CMG) , Intuitive Surgical (ISRG), Baidu (ISRG) and Broadcom (BRCM). Given their high valuation and middling scores, I see no reason to own these stocks right now.

The other thing I note is that almost all of the large-cap real estate investment trusts have a score of 5 or lower. This group is overbought, overvalued and over-loved by asset allocators. As much as I love real estate as an asset class for the next decade, the large-cap REITs are priced for perfection and beyond. REITs with scores below 5 include Equity Residential (EQR), Prologis (PLD) and SL Green (SLG). Given the high valuations and low F-scores, I would not be willing to own the group and would consider shorting these names if they continue to rise.

Telecom companies do not fare much better. Both AT&T (T) and Verizon (VZ) have F-scores of 5, and I believe it's highly unlikely that these stocks do any better than the broad market for the next year or so. Both have had a great run the past few years, but there is no solid reason to buy them here. Century Link (CTL) has also done very well, but its F-score indicates a strong possibility that it will lag the market going forward.

One of the biggest stocks out there with very high valuation and an F-score indicating underperformance is Facebook (FB). I like the service and have a fairly active Facebook account that I use to keep in touch and share ideas with friends and family all over the world. In spite of that, I have been skeptical and bearish on the stock since day one. I do not believe the company will figure out how to monetize its user base under the current model. I do not know anyone who clicks ads on the site or buys products on the basis of Facebook pages. I don't believe it will ever convert to a subscriber model either. Facebook will be with us for a long time, I suspect, but it won't be the wild growth stock that some expect. Since it has very high earnings and asset valuation and an F-score of just 4, I would avoid the stock and short strength in Facebook.

Now that I have embraced my inner cynic, I will get back to my bread and butter and spend the rest of the week sharing some F-score-based discoveries of safe and cheap stocks as well as long shots that have a high probability of hitting the jackpot in the years ahead.

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