Whatever You Do, Avoid These 3 Stocks

July 25, 2013

As companies emerge from a rough stretch, their shares can quickly move back into favor with investors.

Trouble is, the rebounding share price can often overshoot the mark and move into overvalued territory, especially if there has been a massive short squeeze in play. Here are three fast-rising stocks that have rapidly moved from being undervalued to overvalued.

Best Buy (NYSE: BBY)

This beleaguered electronics retailer has seen its stock more than double this year as an extended period of quarterly profit shortfalls appeared to come to an end.

Best Buy had been steadily losing traction as its prices were higher than online rivals such as Amazon (Nasdaq: AMZN) and Wal-Mart (NYSE: WMT). In response, Best Buy has been slashing prices, which has reduced gross margins but helped stabilize foot traffic.

To offset the lower gross profits, management has been radically paring overhead, including sales staff. Note that Best Buy’s business model once depended on a knowledgeable and friendly sales staff. Fewer salespeople means a lot more standing around for consumers, waiting to get their questions answered (which has been my experience on recent occasions). At some point in such an environment, shopping online becomes the easier option.

More to the point, this stock’s rebound has eliminated any sense of this stock being a value play. Shares now trade for more than 10 times consensus fiscal 2014 earnings per share (EPS) of around $2.40.

What’s an appropriate earnings multiple for a retailer with limited growth prospects and ever-deepening competitive pricing pressures? “We believe that 8X is a reasonable multiple given our view of the company’s risk profile, EPS growth trajectory, and recent low-quality earnings,” said analysts at Citigroup, adding that they expect shares will fall to their $19 price target.

Analysts at Merrill Lynch said, “While cost reductions so far have been impressive and we believe there will be more to come, we think these initiatives will be insufficient to return earnings and cash flow to attractive levels in the next few years.” That view underpins an $11.50 price target, which is less than half of the current stock price.

Chipotle Mexican Grill (NYSE: CMG)

Holy guacamole! This stock has risen more than $100 in just six months, to a recent $370.

The credit goes to a string of impressive quarterly results as last year’s slowdown in profit growth appears to have abated. Chipotle has topped profit forecasts by exactly 16% for four straight quarters.

Investors may see a smooth ride to higher profits, as EPS is expected to rise roughly 20% in 2013, 2014 and again in 2015, when this company will be earning $15 a share, according to analysts at Citigroup.

Yet that view may prove to be too optimistic. Goldman Sachs analysts think sales growth will start to decelerate, partially due to the fact that same-store sales, which used to rise at a high-single-digit year-over-year pace, are now growing half as fast. And they think that Chipotle’s heady expansion is leading to oversaturation in some markets, noting that recently opened stores aren’t generating the initial traffic results that store openings used to generate.

And Goldman’s analysts think that as Chipotle enters a more mature growth phase, the stock price will be impacted. “We do not believe in-line growth is likely to support a superior multiple, as was the case in CMG’s hyper-growth heyday. As such, multiple contraction may serve to offset the compounding EPS base, limiting shareholder returns over the next few years.” They see shares falling $50 from current levels to a $320 target price.

H&R Block (NYSE: HRB)

Shares of this tax preparation service have risen more than 50% this year on hopes that the imminent major changes in health care stemming from the Affordable Care Act will make personal income taxes so complex that consumers will flock to H&R Block for help.

But will that really be the case? After all, tax prep volumes for the season just ended were down 0.9% compared with a year earlier for H&R Block, mirroring pressures seen by Intuit (Nasdaq: INTU). Additionally, in the past few years, this industry has evolved into a slowly growing, mature market.

What impact will the Affordable Care Act have? Well, there is sure to be some confusion around its implementation. Many consumers are likely to need help figuring out which health care subsidy they should receive, or what health care taxes they might owe.

In response, the U.S. government is planning a major PR blitz later this year to inform and educate consumers, including explicit tax information. So it’s probably too soon to expect any bump for H&R Block and Intuit.

Risks to Consider: As an upside risk, these stocks each has a short interest that is equivalent to at least two days’ trading volume, and rising stock market could squeeze them higher.

Action to Take –> These bull market stocks appear to have been lifted by the sense that troubles in 2012 have been replaced by blue skies ahead in 2013 and beyond. Yet such a sunny view should invite caution, as the fundamentals underpinning each of these stocks’ gains appear to be on shaky ground.

P.S. — StreetAuthority’s Amy Calistri has one objective for readers of Stock of the Month: to provide one quality stock pick each month, with in-depth analysis in plain English that investors can understand. In fact, she just released a special presentation, “How to Beat the Stock Market… In Just 12 Minutes per Month,” that tells you more about her strategy. Go here to learn more.