Whole Foods Beginning to Spoil

 | Nov 01, 2012 | 12:00 PM EDT
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Famed money manager Peter Lynch was a big advocate of investing in what you know -- simple advice that has produced many winners over the years within my own investment portfolio. I've scored some pretty impressive gains by investing in companies whose products I consistently use. One of these has been Starbucks (SBUX) -- I hate to admit it, but I am a complete addict, even though the coffee is average. Another was Williams-Sonoma (WSM), whose offerings are overpriced, but which has some great stuff if you are a foodie. Finally, there was PF Changs (PFCB), which I bought before its buyout. The restaurant's orange peel chicken is still amazing.

I also believe this philosophy can also work on the short side. For example, I used to go to Best Buy (BBY) once a month, but now I shop online at Amazon (AMZN) and have not set foot in a Best Buy store this year. Unfortunately, I missed that opportunity.

One stock I did just short is Whole Foods Market (WFM), which operates approximately 340 natural and organic-food supermarkets in the U.S., Canada, and U.K.

During my first six years in Miami, I went to Wild Oats (now part of Whole Foods) in Miami Beach at least twice a week. It was the only game in town if one wanted a good selection of organic food, a wonderful assortment of cheeses or other hard to find marinades, spices and other food knickknacks. The regular grocery stores did not carry a lot of these items, and Whole Foods did not have a real competitor in this fast-growing niche.

Over the last couple of years, I have noticed that this has changed on both fronts. As a result, I probably go into a Whole Foods once every six months at best. The selection at my local grocery store, Publix, has expanded greatly and is significantly cheaper, and the stores are closer to where I live. In addition, new competitors, such as The Fresh Market (TFM) have started to make their presence known. When I look at Whole Foods' stock, it appears to me that growth is starting to slow and that valuation is stretched at current levels.

Here are four additional reasons that Whole Foods Market shares are overvalued at $95.

● The stock is trading near the high of its five-year valuation range, based on its price-to-earnings, price-to-sales, price-to-cash-flow and price-to-book ratios.

● The company's revenue growth is expected to slow from just under 16% this fiscal year to around 12.5% in fiscal 2013. The stock has a stretched five-year projected P/E to growth (PEG) ratio, as well, of 2.15x.

● The company is showing a divergence between net income and operating cash flow, and I consider this a red flag. Whole Foods has almost tripled its net income over the past three years. However, operating cash flow has only grown at approximately 50% over that same time period.

● Land and construction costs for new stores are likely to go up in the coming year -- the company builds in affluent areas, and real estate prices are recovering. In addition, the stock looks as though it is topping out, and has tried and failed at the $100 level three times now (see chart below).

Whole Foods Market (WFM) -- Daily
Source: Yahoo! Finance

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