Perusing the headlines with my coffee this morning I noticed one from Reuters: "Search for yield drives stocks higher." The article notes that "Analysts at Bank of America Merrill Lynch said last week the search had led to the largest five-week inflow on record to emerging market debt funds and the longest inflow streak to equity funds in two years."
I have been around the markets for three decades now and the phrase "search for yield" is the stock market equivalent of cordless bungie jumping. It certainly is not a valid reason for stocks to have a sustained move, especially after seven years of rising prices. I have a very hard time seeing a happy ending for all those rushing into stocks in search of yield.
With that in mind let's continue looking at a group of stocks that I believe are exceptionally prone to an unhappy ending for investors if and when the market experiences a meaningful pullback. These companies are not expected to grow much over the next three to five years but trade at very high valuations and are very vulnerable to a steep and lasting decline in their stock price. They should be avoided by all but the most nimble traders.
Caterpillar (CAT) may be the poster child for overvalued stocks with very poor prospects. The company is the leader in earth-moving equipment and also has a large share of the market for electric power generators and engines used in the oil and gas mining industries.
While Caterpillar is a good company, its current valuation is just too rich. It has a single-digit growth expectation over the next several years but could struggle to reach that low bar if the global economy does not begin to recover at a faster pace. And any further weakness in the oil and gas industry could place additional pressure on long-term earnings growth. Despite this, the stock has an enterprise value/EBIT ratio of 32.
But investors have piled into the stock regardless of a 40% earnings decline this year because it pays a good dividend. Even after rising roughly 25% in 2016, CAT still yields 3.7% and that looks very attractive in a yield-starved world. However, no matter how appealing the dividend is business is horrible.
On the recent earnings call Caterpillar Vice President Michael Dewalt told investors, "We have sluggish economic growth throughout the world in general, but not enough to drive growth in our end markets. And the news we've seen over the last few months is definitely not giving us more confidence."
There really is not a great reason to own Caterpillar stock, and return to a more normalized valuation would mean losses well in excess of the dividend payout.
Shares of Merck (MRK) jumped earlier this week when it was announced that competitor Bristol Myers Squibb's (BMY) lung-cancer drug did not do as well as old-fashioned chemotherapy in tests. Merck's rival drug has fared much better and, at least for now, the company will have a strong advantage in the lung-cancer market.
Still, Merck's advantage will not be long-lived as there is an enormous amount of research being done on lung-cancer drugs and companies such as AstraZeneca (AZN) have promising drugs in development.
I have done well with big-pharma stocks by buying them at single-digit price-to-earnings (P/E) ratios with dividends north of 5%. By comparison, Merck today has a P/E over 30 and a yield of less than 3%. Its current EV/EBIT ratio is almost 30 and the company's estimated three- to five-year growth rate is around 5% a year.
Merck may be a great company but the stock is not a bargain or even reasonably priced at current levels.
Two real estate investment trusts also made my list. I am a huge fan of REITs but this is a sector where valuation matters. Both Federated Realty (FRT) and Essex Property Trust (ESS) are trading at nosebleed valuations and yield less than 3%. In addition, FRT and ESS have EV/EBIT ratios of more than 30 and expected growth rates in the low single digits.
There are better alternatives available in the REIT sector.
Ignoring fundamentals in the chase for yield is likely to result in an unhappy ending. Investors should avoid companies with high valuations and low expectations.